Forex trading can be an exciting and potentially lucrative investment opportunity. However, it can also be a risky venture if proper strategies are not implemented. One of the most important strategies in forex trading is forex hedging.
This strategy can help traders reduce their potential losses and increase their chances of success.
What is Forex Hedging?
Forex hedging is a risk management strategy used by traders to protect against potential losses arising from their open positions.
Hedging in general involves taking an offsetting position in a different currency or instrument. In doing so, the trader aims to reduce the risk of losses in case the original position experiences negative market movements.
For example, if a trader buys a currency pair and fears that the price may drop, they can hedge their position by selling a similar currency pair. This will limit their potential losses if the price does indeed fall.
There are both pros and cons to hedging. If not applied properly, hedging can maximize losses. Hence, it is not as simple as going long in one position and short in the other.
As this article will reveal, there is more to hedging than just offsetting one’s positions. But first let’s look at the different types of hedging strategies.
Types of Hedging Strategies
There are several hedging strategies one can implement. Each has its own advantages and disadvantages. Some of the most common strategies in hedging include:
- Simple Hedging: This strategy involves taking an offsetting position in a currency that is negatively correlated with the original position. For example, the EURUSD and USDCHF are inversely correlated. Hence, a trader may go long on one currency and short on the other.
- Cross Currency Hedging: This is a hedging strategy involving taking a position in another currency that is not directly related to the original position. For example, you can be long on the EURUSD and hedge this position by going long on the GBPJPY.
- Options Hedging: This strategy is applicable to options that are another class of financial instruments. Traders can hedge their bets on the underlying position by taking a CALL or a PUT option contract.
- Futures Hedging: Similar to options, this involves hedging the position in the underlying market by taking an opposition in the same futures market.
These are sophisticated trading strategies and are largely employed by institutional traders. For the average trader, unfortunately, one is limited to the simple and the cross currency hedging. Unless of course, you also have options and a futures trading account.
Some MT4 brokers also offer futures as a trading instrument but seldom do these instruments allow for hedging. For example, you can find futures contracts pertaining to agricultural commodities, but no forex futures.
How can you benefit from using a hedging strategy in forex?
There are some clear benefits that a hedging strategy can offer. But it takes a lot of work and background research. However, below are some of the benefits of using a hedging strategy.
- Reduced Risk: Hedging reduces the risk of loss in case the original position experiences negative market movements. Since hedging is a form of insurance, your returns are lower, but your risk is also lower.
- Flexible: Through hedging, traders can engage in multiple financial instruments. It diversifies risks. But still, this is no guarantee that the markets will behave as they should. Even hedging carries some form of risk, but is considerably lower.
- Improved Portfolio Management: The overall performance of one’s portfolio can be improved when hedging. But again, this is largely applicable if your hedging strategy involves using multiple financial instruments.
Hedging is a valuable tool in your arsenal. It serves as a good way to improve risk management techniques. When utilized properly, it can increase the chance of your success in day trading or swing trading the markets.
Hence, traders should take time to develop a thorough system that utilizes hedging in the right way. If you rush things through, there is a good chance that cutting corners will be an expensive price to pay.
Implementing a forex hedging strategy
Traders need to take a holistic view of their trading when it comes to implanting a forex hedging strategy. It is a lot more complicated than just analysing one instrument or the same class of instruments.
Still, here are some tips to help you get started in implementing a forex hedging strategy.
- Determine Your Risk Tolerance: It is important to understand your risk tolerance before implementing a forex hedging strategy. By knowing your risk tolerance you can determine the appropriate level of risk that you will take.
- Hedging Instruments: Choosing the instruments you will use for hedging can be important. A wrong calculation can leave you in losses on both ends. In this case, you are not insuring your trades, but rather increasing your risks. Hence, you should have a good understanding of the instruments you want to use in hedging.
- Fees and costs: There is a fee to pay for everything. Be it a spread markup or a commission. Hence, it is best to know these fees upfront before using the instruments in question. Futures contracts in general are commission-based, but forex CFDs incur a spread markup and/or a commission. Additionally, you also have the overnight swap fees to pay as well.
How to be successful in hedging forex?
In the previous section, we outlined the key factors needed to implement a forex hedging strategy. Let’s now take a look at how you can make your hedging strategy more successful.
- Keep it Simple: Hedging is only as complicated as you make it to be. Keeping things simple when it comes to implementing a hedging strategy is the best. Since you will be dealing with multiple instruments, the simpler the strategy is, the easier it is for you to manage it.
- Stay Consistent: Sticking to a consistent approach or strategy is essential. If you start changing things around after every unsuccessful hedge, then you won’t get much far. Bear in mind that at the basic level, you should begin with a trusted and well-tested hedging strategy.
- Stay Informed: Depending on the financial instruments you will hedge with, you need to stay on top of the markets. This means following the news including economic developments and speeches, all the way through to the macroeconomic level.
- Limit your risks: Hedging is after all ensuring your trades and lowering your risks. But within each trade, you need to limit your risks. The markets can be erratic at times and defy logic. Hence, it is in your best interests to also limit the risks in the individual positions you take.
- Manage Your Emotions: Since you will be dealing with multiple instruments, it is good to keep your emotions in check. In fast-moving markets or some big news release, the markets can chop around. This can make your hedging strategy worthless at times. Emotions can easily creep in. Keeping this in check only works to your benefit.
What are the common hedging strategies?
There are different ways to bell a cat. Likewise, there are different strategies and methods one can employ. In this section, we will talk about some of the most common hedging strategies one can use when it comes to retail forex trading.
- Hedging through correlation: In this approach, traders pick instruments depending on their correlation. Correlation is a statistical measure that determines how two variables move, relative to each other. There are just two types of correlations; positive and negative. As you can expect, negative correlation instruments allow you to offset your positions, reducing your risks.
- Hedging through asset classes: In this approach, correlation is applied not to the same asset class but to an asset level. For example, the Equity markets tend to be negatively correlatedd with the bond market. Hence, traders can use these as a way to go long on one asset and short on the other. A more advanced example can be that of an interest rate swap and the bond yields themselves which show a high negative correlation.
- Hedging through derivatives: In this method, hedging is achieved by insuring your underlying trade via the derivatives markets. Derivative instruments can be options and futures. These instruments allow you to go long or short in the market. Hence, if you are long on the US equity index but fear that the price may fall, you can short this by buying a PUT option on its equivalent derivative instrument
Example of hedging in forex
Perhaps the most common example of hedging in forex is that of the EURUSD, USDCHF and GBPUSD. The EURUSD and USDCHF are negatively correlated. Likewise, the EURUSD and the GBPUS show a positive correlation.
To offset your risks in EURUSD you can take an opposite position in the USDCHF market. This will ensure that the market movements offset each other. But this may raise a question. If you trade on offsetting instruments, how can that make money?
This is where the skills of risk management and knowledge about the markets matter. There are a few things to consider first.
Identify the costs for these positions. It may include the spread difference between the EURUSD and USDCHF. It can also include overnight fees and so on. Once these costs are accounted for, you can then take a look at position management.
Position management is all about knowing how many contracts long and short you should be in the market. It involves looking at your risk profile and picking the right trading contracts or lot sizes to trade.
Even the simplest of hedging strategies will require enough thought into how many contract sizes and which price levels to enter the trades. Stopping losses on an individual trade is also very essential. Without stop losses, even if your positions offset each other, they can be very risky.
You may end up risking more than you intended to. Hence, using stops, but at reasonable levels on the hedged trades and your main trade is important.
What factors to consider when using a hedging strategy?
There are many factors that come to mind when looking at implementing a forex hedging strategy. Here, we outline a few of them.
- Market volatility: Market volatility is a key factor when it comes to the success of using a hedging strategy. The more volatile a market is, the higher the chances of price movements and this provides trades an opportunity to make money.
- Risk reward considerations: At the basic level, hedging is all about reducing risk. When the risk is lower, your reward is also lower. Hedging is all about finding the fine balance between risk and reward. On one hand, you want to reduce your risk, but at the same time, you need to find a reasonable reward ratio to make the trade pay off.
- Risk tolerance: How much of risk you are willing to take plays an important role in implementing a forex hedging strategy. Traders can of course opt to not use a hedging strategy at all in the first place. Those who have a lower risk tolerance may find that hedging is a good way to reduce their risks.
- Market knowledge: Forex hedging is not for everyone. To be successful, you need to have a good understanding of how the markets work. Thorough research needs to be done to ensure that your hedging strategy is logically sound. You cannot pick any random instruments and expect the hedge to work.
Forex Hedging Strategy – In Summary
To conclude, forex hedging strategies are widely used across all spheres of the trading community. This ranges from the average retail trader to sophisticated trading desks at banks. The main purpose of hedging is to minimize the risks by creating offsetting trading positions.
Hedging can vary, depending on the strategy that you use. It can be as simple as going long and short on the same instrument. It can also include using a mix of different financial instruments as well. A good example of this can be seen with the use of bonds and their CDS (credit derivative swaps).
A CDS is a financial instrument acting as a hedge against a bond’s potential default. Still, no matter how much of precaution you take, there are no guarantees as seen from the 2008 financial crisis.
Forex hedging focuses on hedging on the currency pairs themselves. At times, depending on one’s knowledge and financial prowess, you can expand this hedging strategy to use other instruments such as options contracts or futures.
Forex hedging requires a lot of thought and skill. Hence, traders need to have a very good understanding of the various aspects of market risks, the relationship between instruments, the underlying cost structure and perhaps even more.
