Updated 14 September 2020
Foreign exchange trading, or forex trading as it is more commonly known, is a strategic method of trading in currency pairs with the ultimate goal of making a profit. To do so, traders make use of various approaches and techniques, not least in the area of risk management.
One such technique is hedging.
This article will look at what a forex hedging strategy entails, the different approaches to hedging you can take and how they can be used to mitigate risk on positions in the forex market.
Essentially, a forex hedging strategy is a way of ‘hedging your bets’ and is one of several methods of risk management used by experienced traders. By implementing a forex hedging strategy, you are placing a level of protection on your currency exposure.
Typically, hedging strategy protection is a short-term approach applied to a long-term investment. It is used to mitigate potential losses that could result from news or events influential to the forex market.
Say you go either long or short on a currency pair and speculate significant movement in your favour over time, but an upcoming economic announcement is likely to result in market volatility and could lead to movement in your currency pair in either direction.
Instead of closing your position, which would mean missing out on the profit you predict once the market stabilises, you want to protect your exposure from the temporary volatility. This is when you might want to consider a forex hedging strategy.
There are several approaches to a forex hedging trading strategy. The more complex and systematic methods tend to form part of wider risk management strategies adopted by institutions or corporations with interests in the forex market.
For the retail forex trader, however, there are generally two types of hedging strategy commonly used.
The next section will look at both in detail, as well as discussing a third option – hedging with correlating currency pairs.
Having discussed the basics of what a forex hedging strategy is, we’ll now look at the most common approaches and how they can protect you from potential losses on currency pairs in your portfolio:
When you open a trade on a currency pair, you usually choose to do so in one of two directions, based on your predictions of future market movements.
If you suspect an upcoming event may have an adverse effect on your current position but that the market will eventually reverse in your favour, you can hedge your investment by placing both a short and long trade on the same currency pair at the same time, effectively implementing a no loss forex hedging strategy.
In simple terms, if you have a long trade open on a currency pair, you would also set a short trade to open should the value fall to a certain level. By doing so, you offset the loss on your long trade with the profit from your short trade. This strategy is known as direct hedging, also commonly referred to as a perfect hedge.
Whilst simple in theory, the realities of direct hedging are more complex. Once your hedge opens, you’ll have trades open in both directions. As you’re losing money on one and making money on the other, your net profit will be zero.
You’ll need to have a closing strategy in place to make sure you start gaining profit as soon as possible on your original trade once the trend reverses.
An alternative forex hedging strategy is to make use of options.
To protect your position against market volatility, you can choose to buy put or call options, depending on the direction of your trade.
Options can be thought of as short-term insurance policies and, as such, involve the payment of a premium. Since you pay this premium regardless of whether you close or hold on to your position, options are not a no-loss forex hedging strategy.
To put it into practice, you would purchase a put option if you were long on a currency pair but had concerns that influencing factors may cause the value of the pair to fall. A put option allows you to set a strike price (that is, a price at which you are willing to sell) and an expiration date for the sale to be made at that strike price.
If the value was to fall, your loss would be limited to the cost of the premium to be paid to the option seller, plus the difference between the strike price and the price of the currency pair at the time you purchased the put option.
This difference is measured in pips (price in percentage – the unit by which profit or loss is determined in forex). If the value moves in your favour and continues to rise, your loss would be the put option premium only.
You go long on GBP/USD at an opening position of 1.2957 and purchase a put option with a strike price of 1.2937. GBP/USD falls to 1.2929 but your loss is limited to the 20 pip difference of your initial trade price and your strike price, plus the premium.
Alternatively, GBP/USD rises, your option expiration date passes, your option ceases to exist and your loss is the cost of the premium only.
A call option is the same process applied to a short trade. So, instead of choosing a price at which you are willing to sell a currency pair, you choose a price at which you are willing to buy.
A third option is to hedge using two negatively correlated currency pairs, such as EUR/USD and USD/CHF, where the US dollar is the counter currency. As a negatively correlated pair, if EUR/USD rises, USD/CHF is likely to fall respectively.
By going long on EUR/USD and short on USD/CHF, you’re protecting your USD exposure by having buy and sell trades open at the same time, each moving in opposite directions. However, this strategy is risky, as you’re also exposing yourself to fluctuations in both EUR and CHF.
To make the most effective use of a forex hedging strategy in this way, you really need to deal in multiple currency pairs, have a sound understanding of how they correlate and, more crucially, how this relationship can offset the movement of all the currency pairs in your portfolio. As such, this strategy is only suitable for highly experienced traders.
As in any financial market, risk management is a crucial part of successful forex trading. To open a position without first considering the potential loss and how to protect yourself from it is to expose your interests to potentially devastating market volatility.
Experienced traders use a variety of techniques to cover their positions and will skilfully select which strategy to apply to any given situation. In the case of hedging, this will usually be to protect a longer-term investment from a temporary decline against their trade, simultaneously limiting potential losses to a fixed amount.
This makes hedging a good alternative to a stop loss if you speculate the market will significantly favour your position in the long run. To use a stop loss is to risk closing your trade, accepting any associated loss and eliminating your potential for future profit.
Of course, you could always open a new position at a later date, if you have the capital to do so, but if your faith in the market is strong, then hedging is most likely the better option.
Ultimately, your decision on whether or not to implement a forex hedging strategy comes down to your knowledge of market swings, how confident you are in your long-term position and how much risk you are willing to expose your trade to.
As discussed, a robust risk management strategy is vital to success in forex trading. Hedging, when used with skill, can help turn a potential loss into a break-even or profitable trade. That said, hedging is not without its downsides and should be used with caution.
Below are the main disadvantages of using hedging strategy protection.
To implement a successful forex hedging strategy, you need to be comfortable with, and confident in, the processes involved. These can be somewhat overwhelming if you’re new to forex trading and, if used incorrectly, can actually do more damage than good.
If you intend to use hedging in your wider risk management strategy, you must gain experience before hedging a live trade. Demo accounts are a good place to start since they simulate a real trading environment without the need for financial investment.
As any experienced trader knows, the more risks you take, the more rewards you’re likely to gain. It, therefore, stands to reason that by mitigating risk, you also limit your chances of reward (in this case, your profit).
A good forex hedging strategy is one used sparingly that protects you from a major loss in the short term, but does not excessively damage your potential for long term profit.
Depending on the approach you take, your profit can be dramatically affected by a forex hedging strategy. In the worst-case scenario, it could be wiped out completely and you could find yourself faced with a loss.
Although intended as protection, hedging is a risk so you’ll need to be sure you have sufficient funds in your account to cover that risk. You’ll also need to consider the amount you have available to open a new position, if placing a direct hedge or to cover the premium if using options.
If you’re a small-time trader with limited capital, you might want to consider using minimal stop losses instead, while you allow your funds to grow.
To recap, a forex hedging strategy is a way of protecting an open position against potentially adverse movements in the market. It is a technique most commonly used in response to news and events that are likely to result in volatility. It’s important to remember that any form of trade is a risk, and there is no sure-fire way to insure your investments against loss.
Forex hedging is complex and takes skill and experience to implement successfully. You’ll need to develop confidence in speculating on market swings, learn what external factors are likely to influence them and understand how different currency pairs work in relation to each other.
Traders new to the foreign exchange market should tread carefully, and you should never risk more than you can afford to lose.
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