What is hedging in forex?
Hedging in forex is the method of reducing your losses by opening one or more currency trades that offset an existing position. The goal of hedging isn’t necessarily to completely eradicate your risk, but rather to limit it to a known amount.
The forex market is the largest and most liquid market in the world, which makes it extremely volatile. While this volatility is often viewed as an accepted part of the FX trading experience, various hedging strategies can be employed to reduce the level of currency risk associated with each position.
Types of currency risk that forex hedging can protect against include changing interest rates, inflation levels, and unexpected news.
How a forex hedge works
Hedging forex works by opening a position – or multiple positions – that move in a different direction from your existing trade. The hope is that you’ll create as close to a net-zero balance as possible.
While you could just close your initial trade, and then re-enter the market later, using a hedge means you can keep your first trade on the market, and make money with a second.
Forex hedge trade example
Let’s say you were long on USD/JPY, having opened your position for ¥108.50. You expect a sharp decline in the Japanese yen today, so decide to hedge your exposure using a daily put option on USD/JPY with a strike price of ¥106.
If at the time of expiry, the price of the yen had fallen below ¥106, your option would be in the money. The profit you’d earned could be used to offset any losses to your long USD/JPY trade.
However, if the yen had risen in value instead, you could let your position expire worthless and only pay the premium. The profit to your long trade could offset some or all of this cost.
Forex trading hedging strategies
Various hedging strategies can be used to reduce currency risk exposure. The two most common forex hedging strategies are:
- Direct hedging
- Correlation hedging
1. Forex direct hedging strategy
The first strategy is known as a direct forex hedge. This is when you already have a position on a currency pair, and you open the opposite position on the same pairing.
For example, if you were long on GBP/USD, you would open a short position with the same trade size.
The outcome of this trade would be a net profit or loss of zero, depending on the costs of opening each trade. While a lot of traders would simply close out the initial position, accepting any loss that they incurred, a direct hedge would enable them to make money with the second trade that would prevent this loss.
Direct hedges aren’t necessarily facilitated on a lot of trading platforms, as the result is a complete net off of the trade. On City Index accounts, our standard setting is ‘First in first out’ or FIFO, which means that your positions would net off. However, you can edit that setting in platform to give yourself the flexibility to have multiple positions on the same market.
2. Forex correlation hedging strategy
A common hedging strategy is seeking 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, GBP/USD and EUR/USD are the most frequently cited as having a positive correlation. This is as a result of the relationship between the UK and EU both in terms of geography and political alignment – although the latter could change in the coming years.
So, if you had a long position on GBP/USD, you could hedge it with a short position on EUR/USD.
When you use a correlative hedging strategy, it’s important to remember that your exposure now spans multiple currencies. While the positive correlation works when the economies are moving in tandem, any divergence could impact the way each pair moves – and in turn your hedge.
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