How does exactly hedging work?

I know what hedging is, buying and selling at the same time. Do you make the money with the swap or what? Can someone provide me with some details or examples? I've read A LOT of articles and still cannot grasp this concept. Wouldn't you lose money with positions opposite of each other except for swap? Do you close your buy or sell when you feel the direction of the market? Can someone please shine some light on this? Thank you.

Short answer: hedging doesn't work.


Long answer: A while ago, folks were making great money with USDCHF EURUSD hedge on swaps.... Basically the correlation between the two was in favor of the hedge, so folks made swap money PLUS the difference in the correlation.

When the correlation reversed, the system crashed..... the forums were flooded with complaints about blowing their accounts.

These are called "baskets" where you try to get swap based on cancelling out price moves with other currencies. Correlations always change.... you can get lucky or you can get smoked.... flip a coin.

In short, you have no edge.

http://en.wikipedia.org/wiki/Hedging

Complex stock hedging was what most the the quant funds were doing before they got 'smoked' at the end of last year.

In spot forex, hedging between 2 pairs... this is almost certainly true. But you could hedge a spot position with a futures position if the transaction costs are favorable. Or you could use a correlation between commodities and commodity currencies to hedge against sudden changes in either.

This is especially true in commodity-driven businesses. Companies that produce, say, copper might decide to hedge against a sudden decrease in copper prices by buying put options... or a company that's very dependent on the price of grain (like a bread company) or the price of fuel (say a van line or bus service or airline) could buy calls to hedge against the rising cost of fuel.

In short... the generic concept of hedging works fine, but as it's applied to forex it's just a money drain. At best, if done correctly, you go broke slowly. If done incorrectly or at a bad time... it's broke fast.