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Forex Hedging Strategy - Forex Hedging Techniques
Forex hedging is a method of reducing a trader's losses by opening one or more foreign exchange transactions that offset an existing position. The purpose of hedging is to reduce the risk to some extent. If you are new to Forex trading, you can read our another article about “What is Forex trading and how does it work”.
Forex market is quite liquid, as a result it's very volatile hence the risk. Every trader should know that by heart and take steps to reduce it. Hedging, as you already understood, is one of the methods used by traders to reduce the level of currency risks. Let’s dive in and learn more.
KEY TAKEAWAYS
- The purpose of hedging is to reduce the risk to some extent.
- There are two main hedging strategies in the forex market.
- Hedging strategies typically involve derivatives, such as options and futures contracts.
Hedging Meaning in Forex
Hedging in the forex market is the process of protecting a position in a currency pair from the risk of losses.
Question standing before traders is whether to hedge or not to hedge and if they decide to do so, which strategy suits them best. Keeping in mind that hedging is not free and yet it is protecting from potential losses, which might happen from time to time as a result of sharp change in the market.
Hereafter we will try to explain why traders should hedge and what options they have.
Forex Hedging Strategy
It is a form of short-term protection when a trader is concerned about news or an event triggering volatility in currency markets.
There are many hedging strategies out there but all and all we can divide them into three categories known as Forex Hedging Techniques:
Direct hedging - it's when a trader already has a position on a currency pair, and opens the opposite position on the same pairing.
For example, if a trader is long on GBP/USD, he/she will open a short position with the same trade size.
This will lead to a net profit or loss of zero, depending on the costs of opening each trade. Many traders would just simply close out the initial position and accept loss. While a direct hedge would let them make money with the second trade that would prevent this loss.
Correlation hedging - it's when a trader is looking for a correlation between currency pairs. This would involve selecting two currencies that typically have a positive correlation - move in the same direction, and then taking opposing positions on them.
For example: if traders have a long position on GBP/USD, they can hedge it with a short position on EUR/USD.
When traders use a correlation hedging strategy, it is important to remember that their risk is now spreading on multiple currencies. While positive correlation works when economies are moving in tandem, any deviation can affect the movement of each pair and correspondingly traders' hedging.
Hedging with options - To protect his / her position from market volatility, a trader can buy put or call options depending on the direction of his / her trading. Options can be viewed as short-term insurance policy and, as such, provide for the payment of an insurance premium. Since the trader pays this premium regardless of whether he / she closes or holds his / her position, options are not a break-even forex hedging strategy.
In practice, it looks like this, let's say a trader bought a put option when he / she had a long position on a currency pair, but there were concerns that influencing factors could lead to a fall in the value of the pair. A put option allows the trader to set the strike price and expiration date for the sale to be made at that strike price.
If the value fell, the trader's losses would be limited to the value of the premium payable to the option seller, plus the difference between the strike price and the price of the currency pair at the time the put was purchased.
How to Hedge Currency Risks
Currency risk can rapidly ruin profits, especially when the market is volatile. As a result, traders who put themselves in a risky situation in foreign markets: it can be traditional investments, real estate sales, commercial purchase or income generation, it is necessary to take into account the currency risk. Some may feel comfortable with the risk of exchange rate volatility and will try to take advantage of it. Others prefer to avoid such uncertainty. In any case, traders need to consider the risks associated with currency exchange so as not to jeopardize their money.
To start hedging currency risks, there are a few steps every trader should do.
- Trader has to have a clear understanding of his/her financial goals and objectives
- Traders should identify where Forex exposures are, and how that may impact their objectives
- Perform stress test and some scenario analyses
- Check in with your risk tolerance
- When choosing a hedging style and strategy, traders should consider comfortable levels of risk and financial goals
- Match the appropriate hedging products to the strategy
- Traders should track, evaluate and adjust their hedging strategy as circumstances change
If you feel ready to start hedging your currency risk, you can open an account with IFC Markets.
Bottom Line on Forex Hedging Strategy
Hedging does come with money spending, it's like insurance. Forex hedging strategy is a great way to minimize exposure to risk. It helps traders to protect against possible losses, also it can help make a profit. Traders new to the foreign exchange market should tread carefully, and should never risk more than can afford to lose, so using hedging strategies is a good start for beginners.
Novice or not, hedging is complex and requires skill, to implement it properly. Traders will need to develop confidence in speculating on market swings, and identify factors that can most likely influence the market.
