In Forex, hedging is commonly utilized to offset the risks inherent in market exposure and unpredictability in price. Every trader must be aware of the basic hedging strategies to ensure that his/her capital remains protected against the uncertainty of the market. In this article, we go through this and some additional ways that help you safeguard your position.
What is Forex hedging?
It involves protecting one’s position against market fluctuations that move against one’s position. This is done by opening up extra positions to balance the present ones, thereby reducing risk exposure. It is generally a way of protecting one’s capital in the short-term when a trader is worried about particular events or news setting off the volatility in the markets.
Even though there is no guaranteed way to do away with the risk completely, hedging strategies can cushion loss and limit it to a certain extent. The mechanism of hedging in Forex is somewhat different compared to other markets. This is because Forex is inherently unpredictable. Even though some traders may not want to make use of such strategies, thinking that unpredictability is just a part of trading Forex, it ends up as a matter of how much risk you are willing to take.
3 Forex hedging strategies
Hedging is amongst the most utilized strategies to reduce and manage risk. Let’s take a look at the simplest strategies that traders employ.
Simple/Direct forex hedging strategy
This strategy is a cinch to undertake, in that it only requires one to open a position going opposite to one’s current position. For instance, if you have a long position on a pair, open a short one on the same pair to hedge it directly.
Sure, the profit that one takes away from the hedge is net-zero, but one would keep the starting position if the trend reverses. If the position wasn’t hedged, one would be forced to close the position and settle for a loss. However, with a hedge, one would still be able to make some profit on the second trade when the market moves against your first one.
Multiple currencies hedging strategy
This strategy involves selecting two pairs that are correlated positively with each other. Take, for instance, GBP/USD and EUR/USD and then set position on both pairs, but do so in different directions.
For instance, let us say that you have a short position on EUR/USD, and you have chosen to hedge your USD risk exposure and open a long position on GBP/USD. If the value of the Euro fell, the GBP/USD position would end up as a loss. However, it would be cushioned by the profits that you make with your EUR/USD position. On the other hand, if the dollar fell, the hedge would mitigate the loss of your short position.
It should be kept in mind that bringing in more currency pairs into the mix opens one to more risks. In the example above, even though the exposure to the dollar has been hedged, you are now open to exposure on the pound as well as the euro.
With this, there is a possibility that one of the positions will gain more than the other one loses, thereby providing a net profit.
Forex options enable the holder to exchange a pair at a set price before it expires. These are great hedging schemes that allow one to limit exposure by paying only the option cost. For instance, let’s assume you’re long on EUR/USD at $1.20 and you expect it to fall soon. You resolve to hedge the risk with an option at $1.15 set to expire in a month.
If the price falls below $1.15, the initial position would have made a loss, but the option would balance it out. If the pair rises, you could let it expire, and you’d be paying only the premium.
How to hedge Forex
Such strategies are utilized by experienced traders, more often than not, since they necessitate quite a bit of knowledge of the Forex market. Of course, a beginner can also start hedging, but s/he would be required to come up with a plan first.
An important part of hedging is deciding which pair to trade. A major pair will offer much better options than a minor one. This is because the unpredictability of a pair’s movement depends on how volatile it is. How much capital you have will also determine if you’re able to hedge or not, as opening extra positions requires extra capital.
Forex hedging with a robot
Forex robots can be quite advantageous as they do most of the work for traders once they are set up. A hedging robot is specifically designed to minimize exposure risks by opening multiple positions and analyzing trends. All this ensures that one’s capital is cushioned against sudden movements.
Is hedging legal?
Hedging Forex is illegal, at least in the US. But, there is a caveat – not all forms of hedging are outlawed. Mainly, buying/selling the same pair at the same/different prices is illegal. However, it is not illegal in other parts of the world, such as in the EU.
In a nutshell
Hedging is a great option to cushion one’s loss against unexpected market movements, but it all comes at a price. These involve the basic costs of opening a position, but these also mean that some profits will be reduced. Of course, hedging will protect your capital against adverse market movements. But, if it moves in your favor, you’d be making less profit than you would have if you hadn’t hedged. Two things, then, should be kept in mind while hedging:
- It doesn’t guarantee that traders will make more money.
- It is only a way of cushioning the hit that their positions take with price volatility.