Forex Hedging - What Is It, How It Works and Why Use
Table of Contents
- >What is Forex hedging?
- >Why use Forex hedging?
- >How does hedging work in Forex?
- >Forex hedging strategy
- Hedging strategy #1
- Hedging strategy #2
- Hedging strategy #3
- Hedging strategy #4
- >How to hedge Forex risks?
What is hedging? In Forex and business, the term has the same meaning. It describes the practice of protecting capital against loss that may be caused by adverse circumstances on the market. Typically hedging strategies involve opening a position with a negative correlation to the existing one. This way, under any market conditions, the two positions will balance each other. The strategy neutralizes the negative impact of unfavourable primary trade price movements.
Hedging strategies can reduce the risks or fix current profits without closing the original trade, but they won't increase gains. Once you hedge the risks, you limit the potential earnings as well.
Businessmen, corporations, importers, and even crypto miners hedge the market volatility risks using complex approaches that involve buying and selling derivatives such as options and futures. Forex hedging strategy assumes the usage of FX instruments only.
The use of some financial derivatives for hedging resembles the purchase of ordinary insurance. The sense of the practice is that you pay a specific price to protect yourself from events that may or may not happen in the future. In case all runs smoothly, your insurance payments are lost, but you get all the profits expected of the optimistic scenario. However, if the worst expectations turn out to take place, you don't lose much.
FX hedging is different as it protects from adverse market conditions at the cost of losing potential profits. Your initial trade, in this case, gets neutralized by a hedge position. You can open a trade on the same instrument in opposite directions or employ highly correlated assets.
Market participants hedge Forex trading risks when they want to lock in the current profit or loss of an open position they've already got. The reasons for applying FX hedging techniques may be the following:
- some upcoming political or economic events that can cause excessive dangerous volatility on the market
- a trader has some reasons to believe that in the near future the market can go against his open positions
- a trader is unsure about whether he wants to keep the current positions open and needs a break to collect more information on the market conditions before making a final decision
Traders hedge Forex market risks in a relatively short term scope. Once the uncertainty is gone, a trader removes the complimentary trade. He either leaves the original position open to let it fulfil its unrealised potential or closes both, depending on the new circumstances.
A Forex hedging strategy typically starts with the acknowledgement of the risks for a particular open position. Once the trader understands that he doesn't want to close such a position under any circumstances but at the same time understands that the current situation on the FX market assumes some unreasonable risk – he applies the hedge. Forex assets are sensitive to political events and economic news releases, so many traders choose to play it safe.
Let's say your original trade is a long position that anticipates the asset's price will go up.
To hedge such a position, you will need to open a short trade using the same or highly correlated asset. Alternatively, you can long some other FX instrument with a negative correlation to the primary trade's asset. Such a trade will run counter to the original trade's expected price move but will minimise the losses in case the worst scenario takes place, and the price drops significantly.
Once the risk is no longer there, and you want to go back to the original idea that assumed a high expectation of profit for the primary trade, the hedge trade can be closed. Otherwise, if the price went down, you can exit both trades with a gain or loss that you've initially had when applying the strategy.
There aren't too many ways to hedge Forex trading risks. A typical strategy is rather simple. The details and approaches vary depending on the risks that a trader faces and the goals he pursues.
A Forex hedge strategy can aim at partial or full risk coverage. It can also involve the same trading instrument used for opening the initial trade or deal with the assets that correlate with a smaller coefficient, or even in a non-linear way.
Protecting capital from excessive market volatility or avoiding the currency risks on foreign assets is the most popular reason to apply hedging strategies.
The first and the most straightforward way to hedge is to perform an inverse trade on the same asset. This strategy is called 'Perfect Hedge.'
Let's say you have a short trade open on EUR/USD with one lot position size. Your position is currently profitable, but you know that there is an upcoming news release (i.e., Brexit results). Hence, the market is likely to get extremely volatile when the news is published in open sources. Moreover, the numbers in this release will either generate extreme profits for your trade or cause the loss of all the gains you already generated if the numbers are unfavourable for EUR/USD short.
In this situation, you might feel reluctant to close the position. If everything goes according to the initial sell forecast, you might find it difficult to sell EUR/USD again at a favourable price after the market reversal threat is gone. Prices change fast at the time of breaking news releases.
A perfect hedge can resolve the problem. All you have to do in this case is buy one lot of EURUSD and close this trade after the volatility is gone, and you make sure the news assumes the continuation of a downtrend. If not, you can flatten all EUR/USD positions or reverse the original trade.
When you open several positions in a different direction on the same instrument, it is known as 'locking' in Forex. Some brokers don't allow trading locks and instead an attempt to open two positions in opposite directions on the same instrument with the same volume will close the original trade. Therefore, the Perfect Hedge strategy is only possible to implement on a platform that allows this. At FxPro, we allow hedging (lock positions) on all of our account types, except the MT5 account which is 'Netting' by default.
At FxPro, no additional margin is required when hedging by taking the opposite position on the same currency pair. However, if you hedge using another correlated currency pair then additional margin is required.
Using the example above of one lot short EURUSD, the used margin would be around $3933 (based on exchange rate 1.18 and leverage 1:30). If you then open a long trade on EURUSD for the same lot size, this used margin amount will remain unchanged. You can only place hedge trades however if your margin level is above 100%.
Let's say you have a long open trade in EUR/MXN. Imagine the price has come to a strong resistance level, and you need to decide whether you want to fix the current profits or let them build up if the price breaks through the resistance. However, you need to read tons of articles, do some charting, and take time thinking about whether the level is strong enough.
A hedging strategy with highly correlated trading instruments can help to 'pause' your open trade. EUR/MXN has a 97-98% correlation with USD/MXN currency pair. This means you can hedge the trade selling the same volume of USD/MXN pair and take your time deciding what you want to do with the original trade.
Such a Forex hedging strategy can temporarily remove some of the market risks along with the possible profits for your open positions if the correlation between the two currency pairs is close to 100%.
Using the strong negative correlation between the two trading instruments is another way to hedge Forex risks. Negatively correlated instruments move in opposite directions at any given time, so you can neutralize the market risks if you buy the same volume of negatively correlated instruments or sell them simultaneously.
For example, let's say you have a long open trade on EUR/AUD. AUD/CHF has a below -95% correlation with your original trade's instrument, so you can buy AUD/CHF to compensate for potential losses that you expect in the near future for your EUR/AUD long trade.
Hedging strategies do not always involve the use of two correlated assets. In real life, you can protect your business or assets using some forex instruments.
Imagine you have a retail network in Europe that sells fruits. You know that next month you will need to buy €100 000 worth of apples in Poland and pay in Polish Zloty for them. You discover that the deal will be worth the effort only if the PLN/EUR rate remains at the current level.
To protect the business, you might find it reasonable to buy one lot of PLN/EUR and hold this position until it's time to pay for the apples. This Forex hedge strategy will help you in case Zloty currency strengthens against Euros. The profit from the trade will compensate for the increased fruit price. Yet, in case PLN weakens, you'll get to have cheaper apples from Poland but at the same time face some loss on your PLN/EUR long trade.
The idea of hedging Forex risks is often criticized, for it has doubtful efficiency. As each new position involves some trading expenses/cost, it is necessary to determine if the potential benefit of a strategy is worth it.
Traders need to take the spread, commissions, and free margin into account when choosing between closing out their open positions and hedging them.
It is also important to note that hedging will not protect against the potential widening of spreads. This is because the PnL on Buy positions is determined by the Bid price and Sell positions by the Ask price, so an increase to the bid/ask spread will increase unrealised loss or reduce unrealised profit, even though you are hedged.
Careful analysis of potential risks and benefits will help make the most advantageous decision for your capital. It is also a good idea to plan ahead how you will exit the hedge. Under what market circumstances will you flatten your positions or return to the original trade? Answer this question in advance as you will need to act quickly and decisively when the time comes.
Locked Forex positions can't generate much profit. Make sure you return to the original plan once the threat for your initial trade is gone. In case your worst expectations came true, you can close out both trades and fix the profits you managed to protect with a hedging position.