How to Hedge Forex Positions

What is hedge in forex? Hedging with forex is a strategy used to protect one's position in a currency pair from an adverse move. It is typically a form of short-term protection when a trader is concerned about news or an event triggering volatility in currency markets.

Key Takeaways

What Is Forex Hedging?

Hedging means taking a position in order to offset the risk of future price fluctuations. It is a very common type of financial transaction that companies conduct on a regular basis, as a regular part of conducting business. Companies often gain unwanted exposure to the value of foreign currencies, and the price of raw materials.

As a result, they seek to reduce or remove the risks that come with these exposures by making financial transactions. In fact, financial markets were largely created for just these kinds of transactions - where one party offloads risk to another. For instance, an airline might be exposed to the cost of jet fuel, which in turn correlates with the price of crude oil.

How a Forex Hedge Works

Forex hedging involves opening a position on a currency pair that counteracts possible movements in another currency pair. Assuming the sizes of these positions are the same and that the price movements are inversely correlated, the price changes in these positions can cancel each other out while they’re both active. 

Although this eliminates potential profits during this window, it also limits the risk of losses. The simplest form of this is direct hedging in which traders open a buy position and sell position on the same currency pair to preserve whatever profits they’ve made or prevent any further losses. Traders may take more complex approaches to hedging that leverage known correlations between two currency pairs.

Why Hedge Forex?

Hedging in forex empowers traders to protect their positions from adverse market movements, effectively reducing the potential for significant losses.

It plays a pivotal role in preserving capital by effectively mitigating the impact of market fluctuations. This risk management strategy offers a crucial layer of security, shielding against potential downturns in the market. 

Potential Risks When Hedging

While hedging can be a very valuable strategy, it also comes with significant risk and can nullify gains and profits if you aren’t careful about how you use these hedges. The most likely disadvantages of forex trading created by hedging include the following:

Your profit potential will likely be reduced. While a hedge reduces your risk, it also cuts into your profit potential. This is because in cases where profits continue to rise for your initial open positions, your hedged position is likely to decrease in value.

You may lack the expertise to leverage hedging to your own financial gain. Because of the complexity of creating and timing hedges, many beginning forex traders lack the market familiarity and expertise to execute hedges in a way that maximises their value. 

It’s possible that your hedge will also lose money in the event of sudden volatility. While it may not be a common event, hedges—particularly complex hedges, which are not directly correlated to your other positions—are not always guaranteed to gain in value as other positions lose. This is because the variables and events causing these price movements cannot be fully predicted, which means the impact volatility has on your hedged position cannot be fully known. This could lead to even more significant losses than if you hadn’t hedged your position at all.

Advantages of Hedging in Forex

Higher Control Over Risk/Reward Ratio

Forex hedging can reduce your exposure to price changes. Your position will reduce the overall profit and loss, making it easier for you to understand if you’ve made a good or bad investment.

Promotes Diversification

The main benefit of forex hedging is diversification, which is a great way to manage and control risk-taking. If your trades are diversified, you will be able to hedge against downside risk and protect your portfolio against price fluctuations.

Serves as an Insurance Policy

Another good reason to use hedging is that it serves as an insurance policy. Sometimes, you can be uncertain about the costs of your position for a long time. You don’t need to be worried about this when you use hedging.

The longer the contract is, the more it will vary in value. If you’re going to trade in foreign exchange for the long term, it is a good idea to adjust your hedging strategy.

Enables You to Avoid Overpaying

You may be able to find opportunities to increase your income by taking advantage of currency fluctuations. For example, if you have a long position and the price goes down, you can use the same amount of money to open a short position.

If the price goes up, you’ll earn a profit on your short position. If it goes down, you will lose money on your long position, but you’ll also make money on your short position. This way, you’ll balance out the loss and make a profit.

Matches Your Position with an Uncertain Economic Situation

You can also use foreign exchange hedging to match your position with a specific economic situation. For example, a currency may experience increased volatility when the economy is in a slump, or if there is an adverse government announcement, or if a central bank is in the news.

As you can see, there are many benefits to using Forex hedging. They help you control your risk and make trading simpler and less stressful. You will also be able to make a profit, even when there are adverse price movements.

Potential Disadvantages of Hedging in Forex

While hedging Forex offers benefits, it also comes with certain disadvantages that traders should be aware of. These disadvantages include:

Reduced Profit Potential

Hedging forex is primarily focused on risk management, which means that while it limits losses, it also limits potential profits. The hedging positions may offset each other, resulting in limited gains.

Increased Complexity

Implementing hedging strategies can be complex and require a thorough understanding of market dynamics. It may involve using derivatives or correlating currency pairs, which adds complexity to the trading process.

Costs and Fees

Hedging often involves using derivative instruments such as options or futures contracts, which may incur additional costs, including fees and commissions. These expenses can eat into potential profits.

Psychological Impact

Constantly monitoring and managing multiple positions can be mentally demanding and may create stress or confusion for traders. The added complexity can impact decision-making and lead to emotional trading.

Potential Over-Reliance on Hedging

Over-reliance on hedging strategies may lead traders to neglect other essential aspects of trading, such as technical analysis or fundamental research. This tunnel vision can limit overall trading performance.

Forex Hedging Strategies

There are a number of risk management strategies that forex traders can put into place to take charge of their potential losses. Below is a list of strategic Forex hedging systems and hedging examples:

Simple Forex Hedging Strategy

A simple forex hedging strategy takes a position opposite in the same currency pair—for instance, if the investor holds EUR/USD long, they short the same amount of EUR/USD.

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

Complex Hedges in Forex

One approach is opening positions in two currency pairs whose price movements tend to be correlated.

Traders can use a correlation matrix to identify Forex pairs that have a strong negative correlation, meaning that when a pair goes up in price, the other goes down.

The USD/CHF and EUR/USD combinations, for example, are great options for hedging because of their strong negative correlation. By opening a buy position on USD/CHF and a short on EUR/USD, traders can hedge their positions on USD to minimise their trading risk.

Trading with forex options also creates hedging opportunities that can be effective when utilised in specific circumstances. It takes an experienced trader to be able to identify these small windows of opportunity where complex hedges can help maximise profits while minimising risk.

Multiple Currencies Hedging Strategy

A multiple currencies strategy is a great way to insulate against currency fluctuations and (possibly) chalk up a profit, but it’s also a riskier take on FX. That’s because when hedging an exposure on one currency, corporates will subsequently be opening themselves up to at least two additional currency exposures. 

If liquidity becomes an issue across multiple markets or a sustained crash affects several currencies at once, a multiple hedging strategy could totally backfire and result in losses on every single cash position.

Forex Options Hedging Strategy

With an option trade, a company that trades in foreign currencies will have the option of exchanging currencies at a fixed rate on a future date if it wishes to do so. This fixed rate will be a rate at which the company is happy to exchange money.

A key point with option trades is that the company which takes out an option trade has the option of whether they actually use it or not.

Most importantly, a company will be insured against unfavourable exchange rate changes because they have the option of exchanging currency under the option trade agreement. However, they can also benefit if exchange rates change favourably. If exchange rates change favourably, they can opt-out of the option trade and exchange currency at the market rate.

Often option trades are used when a business is unsure about whether or not it will make or receive a payment in a foreign currency. However, they can also be taken out by businesses that have already agreed to either buy or sell in a foreign currency.

Hedge and Hold Strategy in Forex Hedging

Hedging is all about reducing your risk, to protect against unwanted price moves. Obviously the simplest way to reduce the risk, is to reduce or close positions. However, there may be times where you may only want to temporarily or partially reduce your exposure. Depending on the circumstances, a hedge might be more convenient than simply closing out. Let's look at another example - say that you hold several FX positions ahead of a volatile market event.

Your positions are:

Overall, you are happy with these as long-term positions, but you are worried about the potential for volatility in GBP going into the market event. Rather than extricating yourself from your two positions with GBP, you decide instead to hedge. You do this by taking an additional position, selling GBP/USD. This reduces your exposure to GBP, because you are: selling pounds and buying US dollars, while your existing positions have long GBP and short US dollars.

You could sell two lots of GBP/USD to completely hedge your sterling exposure, which would also have an additional effect of removing your exposure to USD. Alternatively, you might hedge some smaller amount than this, depending on your own attitude to risk.

Note that you could also trade a different currency pair: the key aspect is shorting sterling, because it is sterling volatility you were seeking to avoid. 

GBP/USD is used as an example here because it offsets conveniently against your existing long dollar position. Note that there is a consequent added impact on your exposure to the US dollar. Another slightly less direct way of hedging a currency exposure is to place a trade with a correlated currency pair.

Direct FX Hedging Strategy

Direct hedging in forex occurs when traders are already in trade and open the opposite trading orders on the same pair. The hedge forex strategy is utilised by traders who are not sure on how certain events can influence the pair price and want to stay in the position longer. 

On the downside, if the news is positive for the original order, the trader experiences losses from the hedged position. In order to limit the losses, it’s wise to use the stop loss order on hedged positions. The size of your stop loss depends on the environment, the importance of the news and other factors. 

It’s important to note that some brokers do not allow direct hedging and they close out the first position whenever you place an opposite one or merge them. Direct hedging in forex trading is not allowed in some countries, including the USA. The main reason why American financial authorities have decided to ban the practice is to keep the traders from overtrading and paying double spreads and commissions. 

Forex Options Hedging Strategy

In case you want to avoid opening and closing multiple trades in opposite directions on the same currency at the same time, you can use options. Options give traders a right and not an obligation to purchase or sell currencies at a predetermined price, at a specific date into the future. 

Forex options are preferred by many traders due to the fact that the risks are limited. On the downside, traders pay the premium for opening the position. 

Now let’s see the example, let’s say a trader has opened a long position on EUR/USD from 1.07 and everything goes according to the plan. And the price of the pair has jumped to 1.1. In order to protect the position from possible losses, the trader can buy a put option at 1.09. So that even if something unexpected happens, a trader can exercise the option and close position at 1.09, limiting further losses.

Forex Correlation Hedging Strategy

Some forex pairs are in close correlation with each other. The correlation is calculated using the correlation coefficient ranging from -1 and +1. The proximity to +1 indicates that the currencies will move similarly on the charts. The proximity to -1 means that the currencies are correlated adversely. If the coefficient indicates a number close to 0, it means that the currencies are not correlated.

The Forex Correlation hedging strategy involves opening the opposite position to your original position using a closely correlated currency pair. For example, Euro and GBP are widely known to be closely correlated due to the fact that both European and British economies have close ties. In case you’re planning to hedge your risks when trading EUR/USD, you can open an opposite order on GBP/USD. 

On the upside, the correlation strategy is completely legal in all countries and often used by forex traders. 

On the downside, no currency is in complete correlation with another. As a result risks are magnified during divergence. 

Moreover, correlation hedging strategies can also be used in stock markets, when many shares copy the performance of their index, while the index measures the collective performance of certain shares. 

How to Choose the Best Forex Hedging Strategy?

Forex hedging strategies should not be viewed as a trading strategy. It's more like insurance. As with any insurance, it costs money. For options traders, the premium paid is that cost. Traders hedge their long positions from short time price fluctuations that can be caused by economic and political news.

Usually, hedging positions are short-lived and depend on the given situation. The best hedging strategy forex traders can get is the one that best suits their needs. Direct hedging and hedging using correlated currency pairs can be highly complex for novice traders and result in higher losses than intended. 

When hedging, more trades need to be managed. There are more fees to pay. For many retail traders, it's best to avoid hedging due to its complexity. 

How to Hedge Forex

Hedging can be performed in a number of different ways within forex. You can partially hedge in forex, as a way to insulate against some of the brunt of an adverse move, or you can completely hedge to totally remove any exposure to future fluctuations. There are also a number of instruments that can be used, including futures or options.

However, we will concentrate on using the spot FX market. If you own an overseas asset, you may find yourself hedging against foreign exchange risk. Assume you live in the United Kingdom and invested in Nintendo shares prior to the success of Pokemon Go, and you profited significantly after the fact.

And suppose your unrealized profit was JPY 1,000,000. If you desired to halt the profit, you could sell your shares and then convert the Yen back into Sterling. Your profit would be 1,000,000/137.38 = £7,279 at a GBP/JPY rate of 137.38. (ignoring transaction costs).

When to Consider Hedging

The primary motivation to hedge is to mitigate potential losses for an existing trade in the event that it moves in the opposite direction than what you want it to. Assuming you think your trade will go in the opposite direction than what you want over some period of time, there can be a variety of reasons why you may want to hedge rather than close it out, including:

Unrelated to individual investors, hedging done by companies can help provide greater certainty of future costs. A common example of this type of hedging is airlines buying oil futures several months ahead. Airlines hedge costs, in large part, so that they are better able to budget future expenses. Without hedging, airline operators would have significant exposure to volatility in oil price changes.

Start Hedging Forex

It’s advisable to test hedging strategies with a demo trading account because it’s risk free. Then move onto a live platform and start trading once you feel that you’re ready. 

Exiting a Hedge

Exiting a hedge Forex position requires careful planning and analysis. Traders need to understand the market conditions, determine the hedge ratio, close the losing trade first, evaluate the winning trade, consider the timing, and monitor the market trends. By following these steps, traders can minimise their losses and maximise their profits when exiting a hedge Forex position. It is essential to remember that currency markets are volatile, and traders need to be cautious when trading Forex.

Forex Hedging Summary

Hedging meaning in forex – hedging forex is often a complex technique and requires a lot of preparation. Here are some key points for you to bear in mind before you start hedging: