Today I will deal with Forex hedging techniques. This risk management strategy in Forex trading is first of all an instrument to reduce or remove the risks associated with making financial transactions. Besides, some forex traders managed to transform the idea of this method and turn it into a profitable forex hedge trading strategy.
Unfortunately, many forex traders do not realize all benefits of limiting risks, after simple tactics of capital protection fail. So, I want to explain in simple terms Forex hedging strategies so that you can see all the advantages of protecting your deposit before you suffer from significant losses.
The article covers the following subjects:
What is hedging in Forex?
Hedging implies protection against the risk of future price fluctuations of assets arranged in advance. This method allows insurance against unwanted exposure to the risks that resulted from trading in the Forex market and other financial transactions.
Hedging is a financial strategy used to protect a trader from losing trades resulting from adverse moves of currency pairs.
The concept of insurance is the closest to this risk management strategy.
Hedging strategy is used in almost all types of financial businesses but it has a more specific form in the foreign exchange market.
Forex traders often use the so-called correlated currency pairs to hedge against the currency risks.
Correlated pairs move in sync, in the same direction. In addition to positively correlated pairs, there can be used currency pairs with negative correlation, they are also moving symmetrically, but in opposite directions. In this case, a trader opens two long or two short positions. You can learn more about currency pairs’ correlation here.
Hedging involves opening a long position and a short position with the same risk size. Multiple positions can be opened on the same currency pair or two or more trading assets. If a trader selects two currency pairs, they should be positively correlated.
Note on the terminology:
Long position (a long) is a buy position;
Short position (a short) is a sell position.
Another Forex hedging strategy involves opening two long positions on two currency pairs that have a strong negative correlation.
For example, EURUSD and USDCHF have a strong negative correlation. It means when the first pair is rising the second one faces a drop by a related number of points. The Forex hedging strategy, in this case, will look like this:
However, an equal volume of trades is required only in case of perfect or full hedging. There is also a partial Forex hedging strategy as a way to protect your position from some of the risks. You can open such positions when there are strong signals for a particular trading scenario. I will cover the hedging strategies in detail below.
For example, if you are sure that the EURUSD market will be rising then opening the USDCHF of a smaller size will increase your profit compared to the full hedge. However, in the case of a negative scenario, you will compensate for only a part of the losses.
Is hedging legal?
At the national level, hedging and stock speculation are not always considered legal tools of trading Forex risk insurance. Oddly enough, some hedging operations are prohibited even in the United States. One of the prohibitions concerns hedging in the Forex market. It is illegal in the United States to simultaneously buy and sell the same currency pair at the same or different strike prices.
To ensure that hedged positions are prohibited, the CFTC (Commodity Futures Trading Commission) obliged authorised financial services provider to include an OCO (One Cancels Other) order in their platforms. This order prohibits buying and selling the same currency pair. The financial commission also applied the FIFO rule, which requires forex traders to close their open trades only in the order they were opened in.
The main reason for such prohibitions is considered to be double trade costs with an insignificant trading result. They result in brokers making much more profit than forex traders.
Internationally, Forex hedging is considered a legal risk insurance tool. In particular, the EU, Asia and Australia have freedom of choice of methods and strategies used in trading forex. Simultaneously buying and selling the same currency pair is not prohibited there. Brokers actively support this policy of the financial authorities as trade hedging brings them twice the spread bets than regular short and long positions.
How does hedging work in the Forex market?
Let’s consider what hedging is in simple terms. In order to keep your capital protected, the easiest way is to close a trade that may soon become unprofitable. At first, it seems pointless to continue to buy or sell when you can simply exit the market in the breakeven zone. However, in some cases, opening opposite trades may be more convenient than closing them normally. Consider an example of risk-limiting on the EURUSD currency pair.
Suppose that initially, the trader thought the currency pair would continue to move upward rapidly relying on the intrinsic value of the dollar. He decided to profit from the expected growth entering a but trade at the green line.
However, the subsequent downward reversal made the trader reconsider the initial forecast. Instead of closing a long position with a small profit, he minimizes the risk of the price going down further trade with a short position at the closing of the second downward bar (red line).
Subsequently, he leaves the two opposite second trades until a signal for a reversal in the form of a cross shows up. As soon as the bullish sentiment takes over the market, the trader closes the short trade at the level of the purple line.
The resulting profit allows you to manage the risk more freely since it is able to compensate for losses should the downward movement continue. Therefore, the trader can calmly watch the forex market, hoping that after the reversal the value of the asset will begin to grow.
The growth continued just as the trader expected. When the upward movement turns into a flat, which is signalled by several consecutive bars with large shadows, the trader closes the long trade at a price much higher than the opening price.
The trader managed to get double profit from the two trades. In the event of a negative scenario, the trader would not be able to make a profit on hedging and may start losing money rapidly. However, the losses would be minimal. It is precisely due to the possibilityto maximize profits with insignificant risks that experienced traders prefer to limit risks to leaving the forex market in the breakeven zone.
The hedging trade does not have to be opened on the same asset that was used to open the main trade. Moreover, many brokers do not have this function at all. One can always use trading forex financial instruments with a high positive or a strong negative correlation. Here is my article about Forex correlation.
How to hedge in Forex?
Hedging is all about reducing your risk, to protect against unwanted price moves. It suggests opening a position that will reduce the total loss in a negative scenario.
For example, when you buy the GBP/USD and USD/CHF currency pairs at the same time, as they are negatively correlated. If one currency pair starts moving in the unwanted direction, another one will be yielding a profit compensating for the loss yielded by the first one. There various strategies of how to limit risks in Forex:
Buy currency pairs that move in the opposite directions;
Buy and simultaneously sell the currency pairs that positively correlate;
Buy and sell the same currency pair at the same price simultaneously;
- Buy and sell the same Forex trading financial instrument at the same time but at different prices.
The last two forex correlation hedging strategies can be also referred to as locking in. You can learn more about why traders use locks and what you should do if you get a lock in the article that explains everything about locks in trading.
Hedging and using a stop loss
Each trading terminal has an automated take profit function, but it also has a stop loss. A stop-loss is an offset currency risk order that gets you out of a trade if there are any adverse price movements against you by an amount you specify. Beginners do not like using a stop loss as they hope to gain back the loss.
The major error of a beginner trader is to hold a losing trade and wait until the price reverses and turns a losing trade into a winning one.
That is why before you buy an asset, you need to analyze the forex market sentiment and define the maximum drawdown level. If the risk exceeds the amount required by the risk management rule, you’d better have not the obligation to enter a trade.
If the market situation seems favourable, but the potential risk doesn’t allow you to enter a trade with a full lot, you can reduce the position size. Different Forex trading strategies suggest different ratios of a take profit versus a stop loss, but the potential profit should always be bigger than the loss. Besides, you should take into account the spread bets, the difference between the buy and sell prices.
If you want your Forex hedging tactics to be a system, you need to observe just two rules:
Define the level of the stop loss before you enter a trade.
Never move your stop loss once you set it.
It will allow you to solve another problem of beginner traders, a low level of discipline. If you set a level without proper analysis and face a loss, you will analyze the market situation more thoroughly next time.
Currency correlation and Forex hedging
Correlation is a statistical measure of how different currency pairs move at approximately the same time. They can move either in the same direction (positive correlation) or opposite (negative correlation) direction.
Typically, forex traders use the correlation of currency pairs to confirm their forecasts.
One can direct hedge trades using correlated pairs, for example, by opening two positions on two currency pairs with a negative correlation.
It is not easy to calculate the correlation of currency pairs manually, so traders use special technical indicators for this purpose through their retail investor accounts. LiteFinance has created a convenient correlation calculator that shows how much different complex instruments correlate.
Try to calculate the correlation for the EURUSD currency pair using the calculator below:
More information on currency correlation and the calculator itself can be found here.
How to hedge Forex trades?
Let us study an example of hedging in Forex, based on classical technique, using one currency pair EURUSD.
There are two consecutive down bars in the chart (marked with the blue oval in the above chart) as a confirmation of the shooting star pattern (a bearish candlestick with a long upper shadow and a small lower shadow or no shadow at all). So, we enter a short trade of 1 lot at the level of the red horizontal line, around 1.13:
Next, holding a sell position, we see that there is a sideways move instead of a steady bear trend. When there are two up candlesticks with full bodies, which almost engulf the entire bear move, there is a strong risk that the EURUSD currency pair will go up and the uptrend will continue (I highlighted the situation with the second blue oval on the right):
To reduce this hedge currency risk, we enter a position, opposite the first one, of the same volume, 1 lot. In the above chart, the buy price on the currency pair EURUSD is marked with the green line, it is at about 1.134.
Thus, two currency pairs trades will overlap each other and protect our deposit. We fix the level of a potential loss of 400 points (the spread bets between opening short and long positions) under the conditions of strong uncertainty.
Now we can safely track the forex market without fear of significant losses. If the price nevertheless goes down, we will close the long position and take the profit from the short one. If there is a signal of the bull trend continuation, we shall exit the short position, and a long one will start yielding a profit.
An example of Forex hedging strategy
Let us study another example of full hedging Forex options hedging strategy trades. This time, we will additionally calculate the potential loss and profit resulting from exiting the direct hedge.
In the situation, marked with the blue oval in the above chart, we decided that the price should go up soon. So, once the bar closes, we open a long position at 1.08578 (green line).
However, the price continues going down and breaks through the support level at 1.08180 marked with the red horizontal line. There is quite a strong signal of the bear trend continuation. To protect our capital against losses, we shall apply Forex options hedging strategy. To insure against big losses, we will open the opposite position of the same volume at the level of 1.08166 after the down candlestick closes.
Thus, the difference between these two opposite positions is only 0.00412 points. This is the amount of loss that we have limited with the help of Forex hedging.
The chart above shows that the full hedging of Forex options and positions was appropriate. This Forex strategy allowed us to safely wait while the market was moving in the opposite direction. The bull trend resumes after a while.
When the price has consolidated sufficiently above the initial position at 1.08852 (black line in the chart) we exit the short trade, thereby fixing 0.00686 points of losses resulting from the short position (the short entry-level – short exit level). However, the trade itself has not yet been completed, since we still have a long position, opened at 1.08578.
As you see from the chart, there is a strong bullish momentum next. We are following the bull trend and exit the buy position when there emerges a shooting star reversal pattern and two confirming red candlesticks down (highlighted with purple in the chart). We close the position at level 1.09484, marked with the purple line.
Thus, the net profit yielded by the long without taking into account commissions amounted to 0.00906 points (1.09484 – 1.08578), and the total profit from the whole trade – 0.00220 points (0.00906 – 0.00686). As you can see, the total profit was much reduced because of hedging. However, we are fully insured against the currency risk of loss that could result from a negative scenario.
Forex Hedging Methods
Well, we have already studied the example of a simple Forex hedging strategy. Now, let us see what ways of capital protection exist and what peculiarities they have. First, let me describe the parameters according to which the methods of hedging are classified:
Type of hedging instruments
There are foreign exchange and over-the-counter types of hedging complex instruments. Forex pairs hedge trades are entered, as the definition implies, on the foreign exchange with the participation of a counterparty, which, in the case of Forex options, is the brokerage company. Over the counter hedge positions can not be opened on an asset exchange. They are not traded in the market and usually conducted once.
The volume of risk that is compensated
There can be full or partial Forex pairs hedging. The full one insures against risks for the whole sum of the deal. The partial one implies the insurance only of a part of the deal. It is used if there are minor risks.
Buyer or seller
Depending on whether you bet on the price rise or fall, you put a buyer hedge or a seller hedge. In the first case, capital is insured against a possible increase in prices, and the second – a decrease.
Type of trading asset
Forex correlation hedging strategy can be direct or complex hedge. A pure direct hedge involves an opposite transaction for the same trading asset. In the case of complex hedges, the hedge position is opened for a different asset (trading CFDs, commodities, bonds, etc.). In this case, the second asset should correlate with the underlying asset, that is, its price should depend on the price of the underlying asset.
For example, when the price of the underlying asset is moving up, the value of the asset that we used for the hedge should also be moving up or down on an extremely relative scale.
Time of opening the main position
According to this parameter, a Forex hedging strategy can be classical or anticipatory.
In the first case, the opposite position is opened immediately after the main (insured) one. An example of a classical hedge is buying an option covering the main trade.
The second strategy implies putting a hedge long before the insured opening positions, as it happens in the case of buying futures.
Types of Forex hedging strategies
Depending on the above characteristics, there are several types of hedging strategies.
Full hedge or perfect hedge
It involves opening positions of the same volume as the first one but in the opposite direction to buy or sell the same asset. Thus, you fully protect the deposit invested in the first trade from the significant risks of price movement in an unwanted direction.
With low potential risks of price market moves in an unfavourable direction, it is possible to insure the main transaction only partially. In this case, the potential profit increases, and at the same time, the hedging costs are reduced. However, if you underestimate the risks, you may face unforeseen losses.
It involves the purchase of a futures contract at a fixed price with the expectation that the asset will be sold at an optimal price in the future.
Forex cross hedge
This technical indicator method involves opening a position on an asset different from that of the main trade. As I already have written before, an example of a cross hedge is opening long positions on EURUSD and USDCHF.
It is a rather complicated Forex correlation hedging strategy that is recommended only for experienced traders.
It involves opening positions in the underlying asset market and the financial derivatives (insurance) market. The positions will differ both in time and size.
The flexibility of the strategy allows you to choose the best proportions, achieving the optimal ratio of the potential profits to existing trading risks.
Let us study an example:
Suppose you buy 1,000 shares at the beginning of the year and plan to sell them at a higher price in the third quarter. In the second quarter, you put an option to sell 1,500 shares. At the same time, the calculations made allow you to expect with a high degree of probability to make profits from both positions closed at different times.
It involves heading the position on the assets of one sector by a position on the asset of another sector. For example, you can hedge against an unwanted market move in the EURUSD market by CFDs on energy resources.
Most of the covered Forex hedging strategies are employed by traders or funds combining different complex instruments (trading CFDs, stocks, etc.) or even strategies. I have covered in detail some of such systems, namely, the hedged grid Forex strategies, Forex pairs grid and Forex Double Grid Strategy, in one of my educational articles.
Now is the time to summarize the above information and briefly talk about the main pros and cons of hedging.
Advantages of Forex hedging
There are a lot of advantages in employing currency risk-limiting strategies, that is why Forex pair hedging strategies are so popular.
Let us study all pros of using hedging strategies to trade Forex pairs:
1. Universal applicability of hedging.
Due to a wide range of Forex hedging strategies and instruments, it can be applied in any market, for any trading instrument (trading CFDs, stocks, commodities, etc.) and by traders of any level of skills. It is used by individual traders, global investment funds and it can be even an element of economic policies of a whole country.
By the way, common people often use hedging as a strategy, when they, for example, invest in gold or on a foreign currency pair to insure against the risks of the local currency pair depreciation. Another example, on a global scale, is the target program for the development of tourism in the United Arab Emirates, in order to diversify sources of income and reduce dependence on hydrocarbon exports. The state sells “Oil” and buys “Tourism”.
2. Flexibility and versatility of the approach.
This point is a logical extension of the first one. The flexibility of hedging results from the logical simplicity of the approach and, at the same time, the widest range of tools that make the hedging process almost universal and applicable to any transaction. Due to such a wide range of hedging tools, it is subdivided into many types:
- Full and partial;
- Traditional and selective;
- Stock exchange, over the counter and mixed;
- Pure and cross;
- Anticipatory and classical.
3. Risk diversification.
It is a kind of mantra for any investor. Risk diversification can be considered as an example of selective and cross hedging. This definition can be described by the proverb “Do not put all eggs into the same basket!”.
The logic of this statement is quite simple and clear. However, in the financial world, it is not so easy to follow this rule.
Principles of hedging facilitate achieving the facilitation goals for an investor, defining the two major rules: it is the segmentation of assets and the correlation of asset prices in the portfolio.
Segmentation means that the assets in the portfolio should belong to different financial markets, industries, and forms of ownership. For example, a portfolio that includes only cryptocurrencies is less diversified than a portfolio that also includes other assets, for example, shares or bonds.
I think the logic here is clear. The correlation between the asset price is covered in this article and many others in the LiteFinance trading blog. I don’t think I can add anything here.
4. Hedging allows traders not only to reduce the risks but also to make profits.
The primary goal of the hedging strategy is insurance against risks. In this regard, it is often opposed to using a stop loss, which is a big mistake. One could easily describe the principle of hedging as “All that is not lost is earned.” However, speaking of it as a strategy for active trading, the concept of profit takes on a more significant meaning.
Grid trading strategies, for example, give good opportunities to make good profits with almost no risks. Employing this strategy to trade Forex pairs, you can make profits even if there is no clear trend.
Another element of the hedging strategy, which is already actively used by institutional investors to make money, is Carry trades. A carry trade is a low-interest loan in one currency pair and opening deposits with higher yields in another. There are also such financial derivatives as futures and options, whose primary role is hedging. However, these complex instruments are now more popular for speculators in active trading.
5. Relevance of Forex hedging technique
Understanding the principles of the hedging strategy and the ability to correctly employ the strategies are especially important during crises and economic turmoil. Many trading companies, financial institutions and even central banks of various countries have their own simple Forex hedging strategy in order to ensure stable operation in times of high market turbulence.
You may not even think about it, but you always hear or read about hedging strategy in the media. Instead of this word, they often use such expressions as “risk aversion”, “safe haven”, “burning money”, and so on. Whenever we hear in the news that some large investment funds have sold stocks and switched to gold and government bonds, we understand that they are simply hedging risks. We as individual traders can also use popular hedging strategies in Forex options trading.
Disadvantages of Forex hedging
Now, let us have a look at the drawbacks of Forex pairs hedging, they are not that numerous, but still, there are some:
1. There is no guarantee that your deposit is fully protected.
It is a big mistake to believe that hedging is the same as a stop loss. Unfortunately, many beginner traders think so and lose their deposits as a result. You should realize that this method doesn’t guarantee the security of your funds.
Neither does it guarantee you will make profits. Hedging is just an approach to reduce the risks, but not to fully eliminate them.
2. Funds freezing.
Hedging can require quite a large amount of spare funds. This is especially relevant with regard to full hedging when you need to double your investments and open only the second position to cover the first one entirely.
Most commonly, other alternative investments would yield more profits than just being pledged against open transactions in order to avoid losses.
3. Psychological trap.
If you actively apply hedging in your trading, you may have a false feeling that your positions can never yield a loss and your funds are entirely secure. Such a trader uses locking too much, increases the risks, and uses very high leverage.
Such a trader may not use stop losses, as he/she mistakenly thinks that they do not need to stop losses as they can simply lock a losing trade up and wait until the price reverses in a needed direction. However, everything is not that simple in reality. You can learn more about locks in the Forex pairs here.
4. Extra costs.
Hedging usually involves extra costs. When opening a position to limit the risks, you have to pay commission fees. In the case of trading any major currency pair, there can be extra costs that result from the spread bets and the swap fees. Beginner traders usually do not consider these costs when building their trading systems based on Forex popular hedging strategies.
5. High standards for trading skills.
I mean the high requirements for analytical skills and trading experience of a trader or an investor, who wants to use a hedging strategy in their individual trading strategies. Although the logic is simple, it is not easy to apply in real trading. Hedging is a rather serious subject for study, which is primarily associated with a wide range of different instruments and methods.
A newbie should spend much time and effort studying theory. Furthermore, the theory is nothing without practice. Experiments with hedging Forex strategies may often result in losses.
So, the experience will also cost some money. Those who are not willing to spend time, effort, and money, may not satisfy the requirements.
Automated trading with hedging
Hedging Forex with automated technical indicators trading tools or robots can bring many benefits to a trader. Robots maintain the value of the asset at its original level with little or no user intervention and thus free him from the need to perform a lot of routine operations.
Automated systems open additional buy or sell currency positions based on market analysis. Robots assess the likelihood of a trend developing, reversing, its potential strength and duration, and many other factors to ensure that the currency risk is minimized.
Automated hedging Forex is used by both traders and stock speculators and large businesses. For example, Deutsche Bank has been testing the Maestro high risk hedging forex application in the online banking system for several years.
The application allows you to download or manually enter information about your current trading, analyzes the market and launches the procedure for limiting hedge currency risk. One of the advantages of this app is an adaptive approach. Users can download statistics both in the form of aggregated Forex positions and in the form of separate transactions. You can do it as frequently as you want. The user can access the Forex market every day or every hour, upload new transactions and add them to the application’s database.
The functionality of the app allows for full balance insurance. The total currency risk is calculated based on information about the ratio of retail investor accounts payable and receivable, liquidity in the bank account, as well as any hedging transactions in the Forex market. Once all multiple positions are uploaded into the database, the app analyzes the market, calculating the necessary hedge adjustment.
An in-app adjustment is a common transaction that can be entered into automatically or after a review by the user, and modified if necessary.
The introduction of an automatic hedging strategy of Forex transactions based on the Maestro application has shown good results with many Deutsche Bank client companies. However, the practical implementation of automatic hedging forex requires the participation of specialists who can configure the software to perform the necessary tasks.
The same can be said about auto trading using hedge advisors. To get a stable profit from trading, you need to master the theory that can be found in this article, and learn how to apply it.
What is currency hedging?
Currency pair hedging is opening a short position and long trades in order to reduce the currency risk occurring in trading Forex. This financial manoeuvre allows you to eliminate the impact price market swings, in order to make trading similar to a currency foreign exchange which is carried out at a fixed rate.
I will give a simple example of currency hedging strategy. Let’s say you are going to buy USDJPY expecting the currency pair to grow. However, some important news that may provoke short-term volatility should come out soon. With a small deposit or high leverage, even relatively small fluctuations in the financial markets may leave you without any funds in any of your retail investor accounts.
In such cases, it is necessary to think about the high risk and open an opposite trade as a hedge against possible losses. When the market is quiet again and has low volatility levels, the hedge position can be closed, and profit can be then taken from the main trade.
Due to the discrepancy between the set price and the market execution price, spreads and broker’s commissions, you will often incur small losses while opening opposite trades. However, they are worth it if you think about the high risks you could face.
With the right approach, you can also make use of volatility, that is, make a profit from two trades at once, as shown in the example above.
Let’s consider the types of currency risks in more detail and learn more about the methods of limiting high risk exposure with regards to them.
There are four basic types of foreign exchange risks:
Transaction risk, also known as conversion risk is the risk to receive a smaller profit or even a loss resulting from export operations due to negative changes in the exchange rate of the multiple currencies used. It can be reduced by restricting exports, determining the optimal price level for exporters and importers and securities in which they are expressed, by narrowing the time range for receipt and payment of funds, using the currency of receipts to cover costs.
In trading, the insurance against the Forex high risks means entering two trades in opposite directions, which provides a chance of getting both a loss and a profit.
Translation risk (settlement or balance sheet risk). It is based on the discrepancy between profit and loss denominated in the multiple currencies of different countries. For example, a US international company has a subsidiary in Germany.
Consequently, part of its assets is denominated in euros. If it does not have liabilities comparable to US assets, then the euro-denominated assets are exposed to currency high risks. The depreciation of the euro will cause a decrease in the earning value of the parent company, which is expressed in US dollars.
Likewise, a significant excess of liabilities over assets will create even greater risks if the euro price rises versus the US dollar. Therefore, the only way to protect the company’s funds from settlement high risks is to maintain a balance between assets and liabilities.
Economic risk refers to a negative impact of unfavorable currency fluctuations on any aspects related to the company’s activities: commodity circulation, production, demand, production cost, competition, etc. As a result, the company’s market value will decline, as well as its economic performance. Least of all economic risks affect companies that bear costs solely in the local currency.
Hidden risk. It may refer to any of the above. The only difference is that it is not taken into account in the company’s economic and financial policy, that is why it is hidden. For example, one or several suppliers of a company can use imported resources in production, and the price of supplied components can rise sharply as a result of Forex volatility.
There are several ways to hedge forex against the above-mentioned high risks.
Types of Forex hedging
Hedging Forex instruments come into two groups:
Exchange-traded products feature high liquidity, low credit risks, and the clearinghouse guarantees that the other side of any transaction performs to its obligations. However, the type of underlying assets, terms, and conditions of delivery are strictly standardized.
Over-the-counter products (OTC), on the contrary, allows the investor to put forward the most convenient requirements for the type of assets and terms of the transaction, however, they are difficult to find a counterparty, and feature high credit risks and low liquidity.
Futures contracts are agreements to buy or sell an asset at a predetermined time at a specified price. In addition to the Forex market, they are actively used in the stock market and the commodity market.
Futures are popular because one can work with them in almost any of the available markets. They are also standardized and have low margins because you don’t have to invest money into them initially. They are also able to fully compensate for losses regardless of how much the price of stocks, commodities or currency pairs changes.
Depending on the direction of market moves of the price of a financial instrument, there are two ways to limit the high risks. By buying, the investor direct hedges against price increases in the future and by selling, the investor sells the goods to hedge forex against a decrease in their value.
The full hedging strategy of Forex transactions using futures provides 100% insurance against losses. If the risks are hedged in part, the investor will be able to recover only part of the losses. But the profit will also be higher in case of a favourable scenario.
Some traders prefer options to the classic futures trade. Options are offered for futures contracts, allowing you to buy or sell an asset before the option expires. In this case, the company pays a commission called a premium, but it also fully hedges against losses associated with currency risk fluctuations.
Here is a simple example. Let’s say an oil company’s trading plan is to buy $5,000,000 worth of kerosene in a month while its main capital is stored in euros. If the US dollar exchange rate grows by as little as 1% during this time, then the losses will amount to $50,000. If the option is purchased, the dollar value will be fixed at the current level. And even if the company has to pay a premium of several thousand dollars, then such losses will be significantly less than possible currency risks.
A forward contract is a non-standardized contract for the delivery of an asset at a fixed price in the future. These contracts do not apply to exchange-traded instruments.
A swap is a transaction through which two parties exchange the cash flows or liabilities from two different financial instruments. Forex broker swaps are an example of how a company can direct hedges against currency risks resulting from Forex volatility.
Conclusions on using Forex hedging
Hedging strategy in the Forex market is one of the most popular tools to limit exposure to different kinds of trading risks and help you not lose money. With the right application, this method allows Forex traders to reduce the high risks with a minimum loss in profits. However, the only drawback of this method in Forex is at least a two-fold increase in the cost of opening a position.
In the next Forex guide, I will continue dealing with different hedging forex techniques, for example, Forex grid and Forex Double Grid Strategy. Subscribe and stay informed!
Important! Once you finished reading, you need to keep with you some key takeaways about hedging and I recommend you to consolidate learning through the practical application as soon as possible. Open any demo retail investor accounts and test all the currency hedging strategies I covered in this article. Moreover, align your forex trading strategy with your risk appetite.
You can do it right here, in the LiteFinance authorised financial services provider that I used while I was writing this article, it is very convenient and user-friendly, offering unique trading opportunities. You can enter trades to buy or sell on all the currency pairs I mentioned today.
I wish you good luck and good profits!
Forex Hedging FAQ
A hedging strategy is a form of insurance or protection that prevents retail investor accounts from losing money rapidly. Speaking about the trader’s deposit, this method is used to compensate for the risks resulting from unexpected price changes.
Hedging strategy is the practice of opening new positions to insure against the risks associated with existing position. Both positions are usually equal in size. This method is used to balance liabilities in commodities, foreign exchange, securities, forward contracts, options.
There are two basic ways of hedging: buying (buying an asset to protect from potential price rise) and selling (selling an asset to protect against the depreciation risk). However, a reduction in risk also implies a reduction in potential profits. Thus, if you are a newbie it’s recommended to seek for independent financial advisor.
Let us see a classical example of a hedging strategy that will help you avoid losing money rapidly. You decide that the trend will go down and enter a trade with a short position. However, once you enter the initial trade, the trend starts turning up, and you decide to hedge your deposit.
You start trading, enter a buy trade of the same size, thus locking your position. After the price chart looks like moving down, you exit the long trade and make a profit from the short position that remains open.
A partial hedging strategy (opening a position that is smaller in size than the main one) could be applied in case you were almost 100% sure that the downtrend will resume soon. You could reduce the loss in case of a sideways trend by opening two opposite positions at the same time. However, if you lack experience, it’s advised to ask independent financial advisor for help and comply different strategies with your personal finance goals.
There are two approaches to hedging losing trades with foreign currencies. The first assumes protection against additional losses while the existing ones are not recovered. In this case, a position equivalent to the main position is opened in the opposite direction.
The second approach allows you to fully recover the losses but requires you to be extremely careful. One has to open a second trade of a larger volume. For example, if the volume of a losing long position is one lot, and you are sure that the price will continue to fall, then you should open an initial trade with a volume of two lots. Subsequently, it will fully recover the losses and begin to make a profit.
The main danger with this approach is the likelihood of a quick upward reversal. The trader should monitor the fx market in order to notice the signs of a trend reversal in time and have time to close the hedge position or hedge it with another long trade.
To answer this question let us see how to trade beginners, a more experienced trader, and hedge traders. Newbies usually enter one trade of big volume on one or several trading instruments that do not correlate. More experienced forex traders enter with a minimum lot and gradually add up to the position often averaging counter the trend.
Hedge traders use a more complex hedges approach. Their strategy, regardless of the Forex trading system they employ, is based on the maximum diversification of high risks. Besides, they can use multiple trading strategies that differ in the risk level, type of market analysis, and other parameters. I will give a simple forex hedging example: an aggressive strategy may yield a good profit, and, if it fails, a more conservative strategy will compensate for the loss so you will not lose money.
An option is a contract to buy or sell an asset at a fixed price. The trade can be carried out only before the expiration date of the option. Buy contracts are called Call Options and Sell contracts are called Put Options.
Even if the fx market trend goes against the trader’s expectations, he will be able to avoid losses by making a trade at a predetermined price. However, the investor will have to pay a premium to the broker for this trade. That is, the investor has to incur small losses in advance in order to avoid greater losses.
Suppose a company buys a call option for €1,000,000 at a rate of 1.1100. It pays the broker a $300 premium for the contract. If the euro rate grows by 2% by the time the contract expires the net loss will be only $300. By comparison, if you start trading and buying euros without a hedging strategy it would have cost the company $20,000.
P.S. Did you like my article? Share it in social networks: it will be the best “thank you” 🙂
Ask me questions and comment below. I’ll be glad to answer your questions and give necessary explanations.
- I recommend trying to trade with a reliable broker here. The system allows you to trade by yourself or copy successful traders from all across the globe.
- Use my promo-code BLOG for getting deposit bonus 50% on LiteFinance platform. Just enter this code in the appropriate field while depositing your trading account.
- Telegram chat for traders: https://t.me/litefinancebrokerchat. We are sharing the signals and trading experience
- Telegram channel with high-quality analytics, Forex reviews, training articles, and other useful things for traders https://t.me/liteforex
The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteFinance. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.