Hedging in Forex – A Beginners Guide

Hedging in Forex

 

What do Forex and FX stand for?

Forex and FX are both abbreviations for foreign exchange, which is the exchange of one currency for another. Forex (FX) also refers to the foreign exchange market where the foreign currencies of the world are traded, 24 hours a day, five days a week.

The foreign exchange market is not a centralized market, but a market that exists wherever the trade of two foreign currencies are electronically taking place.

 

What is hedging in forex?

Most investors and traders will keep a lookout for strategies to reduce potential risk attached to the exposure of their investments. Hedging is one such strategy that can be utilized.

Hedging itself is the process of buying or selling financial instruments to offset or balance your current positions, and in doing so, reduce the risk of your exposure.

In forex, a hedge is a strategy to reduce the risk of adverse price movements in currencies. Forex hedging is a technique to reduce and minimize your existing exposure to different kinds of risk.

Hedging is short-term protection when a forex trader is worried about damaging news or unforeseen events in the world economy or politics, triggering volatility in currency markets.

By hedging against risks, different players in the forex market strategically take advantage of the available instruments in the market in order to offset unfavourable price movements.

However, keep in mind that hedging will not guarantee additional profit or completely cover you from any risks and losses. Although, you will have some flexibility regarding reducing risk and optimizing the trading process.

It is also important to note that hedging is mostly suitable for trading on the long term.

 

Strategies for hedging in the forex market

Common strategies for hedging in forex are: Simple forex hedging, multiple currencies hedging and forex options hedging.

 

Simple forex hedging strategy

By utilizing a simple forex hedging strategy, a forex trader opens the opposing position to a current trade. For example, if you already had a long position on a currency pair, for example EUR/USD, you might choose to open a short position on the same currency pair. This is also known as a direct hedge.

A position in forex indicates a commitment or exposure held by a forex trader on the forex market. It is a term for a trade that is either currently able to incur a profit or a loss, known as an open position, or a trade that has recently been cancelled, known as a closed position. Profit or loss on a position can only be realised once it has been closed.

A long position is when a trader expects the value of a currency to increase and buys first to sell it later at a higher price. A short position is when a trader anticipates the price of a currency to decrease, and hence, sells the currency first to buy it later at a cheaper price.

Although you would keep your original position on the market ready for when the trend reverses, the net profit of a direct hedge is zero. If you did not hedge the position, closing your trade would mean accepting any loss. However, if you decided to hedge, it would enable you to make money with a second trade as the market moves against your first.

This hedging strategy is referred to as a perfect hedge because it eliminates all of the risk associated with the trade while the hedge is active. However, it also eliminates all of the potential profit.

 

Multiple currencies hedging strategy

In the multiple currencies hedging strategy, a trader selects two currency pairs that are positively correlated, such as GBP/USD and EUR/USD, and then taking positions on both pairs, but in the opposite direction.

For example, say you have taken a short position on EUR/USD, but decide to hedge your USD exposure by opening a long position on GBP/USD. If the euro did fall against the dollar, your long position on GBP/USD would have taken a loss, but it would be lessened by profit to your EUR/USD position. If the US dollar fell, your hedge would offset any loss to your short position.

However, although you would have hedged your exposure to the dollar in the example above, you would have also opened yourself up to a short exposure on the pound, and a long exposure to the euro. Therefore, multiple currencies hedging does come with its own risks.

If this hedging strategy is successful, your risk is reduced and there is the possibility that one position might generate more profit than the other position makes in loss. Although, if the hedge is unsuccessful, you might face possible losses from the multiple positions.

This hedge strategy is generally more reliable when a trader is building a complicated hedge that takes many currency pairs into account.

 

Forex options hedging strategy

Also known as a currency option, a forex option gives the option holder (the buyer) the contractual right, but not the obligation, to exchange a currency pair at a pre-agreed exchange rate on a predetermined future date.

Upon contract formation, the holder has to pay a fee (the premium) to the seller for acquiring the option.

This hedge strategy has the advantage that if the market moves against you, the option protects you by limiting and fixing the potential loss. On the other hand, you can still profit from favourable forex rates should the market move in your direction.

The risks of unpredictable losses can be removed with this strategy and your loss will always be limited to the premium paid.

However, the option seller’s risk is potentially unlimited and therefore, is entitled to receive the fixed premium for taking over the risk.

Example

You have an option on a currency pair of EUR/USD that gives you the right to sell €500 000 and buy $600 000 on June 1. The agreed strike price is EUR/USD 1.10. (The strike price is the price at which the option buyer has the right to either buy or sell the underlying currency.)

You, as option holder, will utilize the option if the exchange rate is 1.10 or lower on June 1. If the exchange rate of the EUR/USD currency pair drops to 1.05, then your profit is (1.10 – 1.05) x 500 000 = $25 000 if you exercise the option. You can also buy back euros in the forex spot market at an exchange rate lower than 1.05.

If the exchange rate was higher than 1.10 you were under no obligation to execute the option and your loss would only be the fee (premium) you paid for the option.

Therefore, you eliminate the upside risk in EUR/USD by paying the premium, whilst you can still profit from a decrease in the exchange rate.

 

A word of caution

Although an important and useful strategy in limiting risks in forex trading, hedging should be planned and executed carefully. Preferably, it should only be used by experienced forex traders who are comfortable with market swings and timing.

Without ample trading experience in forex hedging, your trading account balance could be reduced to zero in no time at all.

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