Hedging is the process of devising a strategy to safeguard oneself against a significant loss. Purchasing automobile insurance is a kind of risk mitigation, or hedging, against the possibility of being involved in a costly accident.
In the forex market, consider of a hedge as a kind of insurance for your position. Hedging is a strategy for minimizing or completely eliminating the amount of loss you would suffer if something unexpected occurred.
What is the Process of Hedging in Forex?
Hedging forex works by starting a position – or a series of positions – that moves in the opposite direction of your current transaction, and then closing those positions. The goal is for you to get a balance that is as near to zero as you possibly can. In contrast to the alternative of just closing your first transaction and re-entering the market later, adopting a hedge allows you to maintain your first trade on the market while making money with a second.
Hedging Methods in the Forex Market
A variety of hedging measures may be employed to decrease the risk of exposure to currency fluctuations. The following are the two most frequent forex hedging strategies:
• Hedging on a direct basis
• Hedging against correlation
1. The Direct Hedging Method in Forex
The first of these strategies is referred to be a straight FX hedging. An example of this is when you already hold a position on a currency pair and decide to open an opposing position on the same pairing. For example, if you were long on the GBP/USD pair, you would create a short position with the same transaction size as your long position.
Because of the fees associated with initiating each transaction, the result of this deal would be either a net profit or a net loss of zero. While many traders would just close out their original position and accept any losses that they had suffered, a straight hedge would allow them to earn money on the second transaction that would prevent this loss from occurring.
Direct hedges are not always possible on many trading platforms, and the outcome is a total net off of the deal in most cases.
2. Hedging Technique Based on Forex Correlation
A popular hedging approach is to look for a correlation between two currency pairings to use as a hedge. Choose two currencies that normally have a positive correlation (move in the same direction) and then take opposite positions on them in order to achieve this result.
As an example, the most commonly mentioned positive correlations are the GBP/USD and the EUR/USD exchange rates. These developments are due to the link between Britain and Europe, which is characterized by geographic proximity as well as political alignment – although the latter may alter in the coming years. You might hedge your long position in the GBP/USD currency pair by taking a short position in the EUR/USD currency pair.
The importance of remembering that your exposure now covers numerous currencies when using a correlative hedging approach cannot be overstated. As long as both economies move in lockstep, the positive correlation will be true; but any divergence will have an influence on the way each pair moves – and therefore, on the value of your hedge.
The Most Important Takeaways
• Hedging, in the context of foreign exchange (forex) trading, is similar to purchasing insurance for your transaction by lowering or covering the amount of loss that might otherwise occur.
• You are protected by a simple forex hedge since it enables you to trade in the opposite direction of your first transaction without having to close your initial deal.
• A forex trader may protect himself or herself against a specific currency by employing two separate currency pairings in the transaction.
• Hedging your trades helps to reduce risk, and if done correctly, it may form a significant element of your trading strategy.
Forex Hedging Made Simple
Some brokers will enable you to make transactions that are direct hedges, while others will not. A direct hedge occurs when you are permitted to conduct a deal in which you purchase a single currency pair, such as the USD/GBP. You may also make a transaction to sell the same pair of currencies at the same moment.
While the net profit of your two transactions is zero while you have both trades open, you may earn more money without taking on extra risk if you timing the market correctly when you close one trade and start the other.
Having a Hedge Provides Protection
It is possible to benefit from a simple forex hedge since it enables you to trade in the opposite direction of your first transaction without having to close out your initial deal. One may argue that it makes more sense to close out the original trade at a loss and then enter a new transaction in a better position to maximize profits. As a trader, this is an illustration of the sorts of judgments you’ll have to make on a regular basis.
Without a doubt, you may close your first deal and then re-enter the market when the market’s price improved. By using the hedge, you may retain your initial transaction on the market while profiting from a second trade that earns a profit while the market swings against your original investment.
Taking a Hedge Back
If you have reason to believe that the market will reverse and move back in your favor, you may always set a stop-loss order on the hedging trade, or just shut it out completely if necessary.
There are a variety of strategies for hedging forex deals, and some of them may be rather complicated. Due to the fact that many brokers do not allow traders to have directly hedged bets in the same account, other strategies must be used.
Multiple Currencies to Choose From
A forex trader may protect himself or herself against a specific currency by employing two separate currency pairings in the transaction. For example, you may purchase a long position in the EUR/USD pair and a short one in the USD/CHF currency pair. Although it wouldn’t be accurate in this situation, you would be hedging your USD exposure nevertheless. The sole disadvantage of this method of hedging is that you are subject to swings in the Euro (EUR) and the Swiss Franc (CHF).
It follows from the above that if the Euro becomes a strong currency relative to all other currencies, there may be a movement in the EUR/USD that is not offset by your USD/CHF position. Furthermore, unless you are constructing a comprehensive hedge that takes into consideration a large number of currency pairings, this strategy is often not a dependable way to hedge.
Options in the Foreign Exchange Market
A forex option is an agreement to perform an exchange at a specific price in the future at a predetermined price in the present. Consider the following scenario: you purchase a long trading position on the EUR/USD at 1.30. A forex strike option with a strike price of 1.29 would be used to protect that position.
As a result of this technique, if the EUR/USD falls below 1.29 during the time period indicated for your option, you will get a payout on that option. The amount of money you get depends on the market circumstances at the time you purchase the option as well as the size of the option. If the EUR/USD does not reach the level within the period set, you will simply lose the amount paid for the option. The greater the distance between your option’s buy price and the market price at the time of purchase, the greater the payment will be if the price is reached within the stated term.