FOREX Hedging Strategies for Gold

Hedging can be described as lowering the risk that you may be exposed to by trading a single currency pair or commodity. It involves the balancing of risk and the creation of an insurance safety-net which will ultimately reduce you exposure to losing but at the same time lower the potential profit available. Most traders would support the idea that maintaining risk at an absolute minimum is far more important in the long run that going for the home-run with every trade.

The way hedging works is to offset any potential losses in one investment with the gains of another investment. The classic example is the haulage company who offset the rise in diesel prices used to run their trucks by buying oil futures. Although this does not mean that their losses are wiped out if diesel prices rise, it does mean that they are reduced due to the fact that the prices of both oil and diesel are highly correlated. Hedging in this way operates across all markets and, although it is not a perfect way to remove risk (otherwise it would be simply called insurance), many large investment firms use it as a strategy to make modest profits with reduced risk.

In the forex market, correlations between currency pairs are easy to see and obvious examples of these are the close relationships between the movement of the EUR/USD pair and the USD/CHF which almost always move in opposite directions. In regards to gold, the relationship between the USD and gold has always been that of a strong negative correlation and therefore they very rarely rally together. The benefits of understanding these relationships can allow a trader to take a long position in gold, bearing in mind that we are in a time of global concern toward the fragility of the major currencies and inflation. This anticipated upward trend in gold can be protected from any large risks by buying USD. Thus, if gold were to suddenly fall it would be alongside a rally in USD and the losses would be minimised. However, if gold continues to push higher, the USD will ideally move southwards at a slower pace and allow the positions to be closed at both a profit and at a loss but with the profit greater than the loss.

Ultimately, gold is seen as a good hedge against currency weakness, especially dollar weakness also known as inflation. One of the reasons for this is that gold is priced in USD so whenever investors sell gold they are effectively buying dollars and vice versa. Alternatively, a strategy which has been fruitful for many traders is to take a currency which moves with the rise in gold. The Australian dollar is closely inked to the movements of gold; it has vast gold reserves and has experienced a sharp rise alongside that of its resource. Whilst it still continues to move to the upside, experienced speculators know that what often seems like a bubble usually is a bubble and may be due a correction of some sort in the future. In this situation, a prudent strategy for investors to go long and buy gold would be to hedge a short position on the AUD. Therefore, gold may continue higher and with the existence of financial uncertainty many would support the view that it is not likely to crash anytime soon. However, a small correction in the price of gold may be enough to trigger a larger correction in the AUD given the multitude of factors which influence currencies and the fact that speculators are often short term traders. This would result in a loss on the long gold position but a slightly larger profit on the AUD and a successful hedge trade with limited risk.

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