Forex Hedging helps limit significant losses and survive falling markets as well as major economic downturns. When you hedge a forex trade, it reduces your investment risk in the market as hedging strategies can successfully help determine how much loss you can endure as a forex trader.
Let’s go deeper to better understand hedging and how you can successfully hedge your trades.
What is hedging in forex?
Forex hedging or currency hedging is a strategy in which you open multiple trade positions to offset any possible currency risks associated with your current position. The goal behind hedging a position is to protect it from any unwanted movement in the exchange rates. Hedging strategies can be used to reduce the overall risk exposure that the forex market faces due to inflation, changing interest rates or similar adverse situations.
For example, let’s say you are trading GBP during the United Kingdom’s elections. To hedge the risk that comes along with trading UK’s currency due to the volatile political sentiment in the country, you choose to include EUR/GBP and USD/GBP in your forex hedging strategy.
To hedge your GBP exposure, you can open a long position for EUR/GBP and simultaneously short USD/GBP. Taking two opposite positions will mean that if the pound appreciates against the dollar, the long position will witness a loss, but the short position will offset it by resulting in significant profits. However, if the pound depreciates against the dollar, the risk associated with the short position will be offset by profits made in the long position.
This means that no matter the appreciation or depreciation in the currency, you will gain profits by offsetting the potential losses.
When should you consider hedging?
- Short-term
Day traders can use hedging to protect short-term gains during periods of daily volatile price movements. Price volatility occurs when a currency pair is overbought or oversold and can take a downturn anytime.
When you have opened a long position in an overbought condition, hedging allows you to open short positions to offset losses. On the contrary, when you have a short position opened in an oversold market condition, you can open a long position to protect your profits against an unexpected market reversal. - Long-term
Long-term investors can also use hedging to protect their positions against unexpected market turns and severe price declines to moderate their overall positions. When you wish to maintain a hedge for a year or more, you can do so by placing a long position (if your original position was short) or a short position (if your original position was long) and keeping it untouched for a few years.
Any price fluctuation during this time should not affect your trading decisions because only when the trade position reaches a year’s time you will incur benefits from the hedged position.
Benefits of Hedging
Strengthens predictability
A hedge strengthens a trader’s market predictions by taking significant market positions. For example, let’s suppose an organization operating in the UK wants to know the value of its expenses in the US.
In that case, the organization can hedge a large part of these expenses concerning the US Dollar and ascertain USD’s value in advance. This will then help them understand the EUR/USD exchange rate movement and make their cash inflows and outflows accordingly.
More time to react
Hedging provides traders with extreme flexibility to enter or exit the market according to the trader’s convenience. This means if a trader has opened a long hedge position, but there is a downtrend in the market, they can exit the market quickly by closing the original short and hedged long position. Whereas, if a trader has a hedged short position opened in the same falling market, they can exit the original long and hedged short position to balance the overall trade value.
Manages risk
Traders can manage their trade risks by opening opposite positions in the same or different currency pair to ensure that no matter the market condition, they reap some gains from the market movement.
Protects capital
Hedging is a risk management tool that is essentially used to protect capital by offsetting losses by taking opposite positions in the same currency pair or a related asset like a forex CFD. Capital is protected against related security price changes, extreme forex movements, exchange rates, inflation, etc.
Locks in profit
Hedging allows traders to lock in some profit percentage by opening positions in both bullish and bearish markets. When a trader has a position in both markets, no matter in which direction the currency pairs price moves, the trader earns something somehow.
- If the prices start falling constantly, a short position in the bearish market help traders have a successful trade.
- If the prices start increasing constantly, a long position in the bullish market help traders have a successful trade.
Top forex hedging strategies
Direct, perfect or simple forex hedging strategy
The forex direct or perfect hedging strategy is when you open an opposite position of the currency pair that you already own to protect your entire position.
For example, if you are going long on USD/GBP, you open a short position on the same currency pair with the exact same trade size. By doing this, you expose yourself to a net profit or loss equal to zero. At times, a direct hedge also enables you to gain some profit by opening the second trade as the trade moves with the market direction.
Imperfect hedging strategy
The forex imperfect hedging strategy is applied to partially protect your already opened position in the forex market. In this strategy, not all but some of the risk is eliminated by using call and put options. If you are in a long position, you can buy more of the put option to reduce any possible downside risk. However, suppose you are in a short position; in that case, you can enter into a buying position for a call option contract in order to eliminate the risk associated with an upside movement in the market.
Correlation hedging strategy
The forex correlation hedging strategy aims at selecting two different currencies moving in the same direction (which also means having a positive correlation) and opening opposite positions for the same.
For example, let us assume that USD/GBP and EUR/GBP have a positive correlation, and you open positions in both of these trades by longing USD/GBP and shorting EUR/GBP to hedge the trade. This would lead to offsetting any loss incurred in either of the two currency pairs with a significant profit made on the other pair.
Cross-currency swap hedging strategy
The cross-currency swap hedging strategy helps in hedging the risk associated with inflated interest rates in the economy. It is done mainly by global corporations or institutional investors in order to avoid incurring losses from adverse market dips. In this strategy, two parties agree on an interest rate at the beginning of the contract and exchange the principal amount and interest payments in the form of currencies.
Hedging options strategy
Forex options is a product that gives you the right to sell or buy a particular currency pair without any obligation to do so. The price is pre-decided, and an options contract comes with an expiry date, before which you must exercise your right or let the contract expire.
You can hedge forex risk by using forex options in the short term. Let us understand this with an example. Suppose you wish to buy a currency pair and make a call option for USD/GBP, with an expectation of the exchange rate prices falling in the future. In that case, you can simultaneously short-sell the same amount of foreign currency with a put option at the same time to profit from the price fall in the future. By doing this, you hedge the risk associated with the falling forex position and protect yourself from potential losses.
Hedging forex with CFDs
A CFD (Contract for Difference) is a contract between the trader and broker to open a position in the forex market without actually owning any currency pair. CFDs are one of the most popular forex hedging strategies that help hedge currency pairs as they are a flexible type of security that allows traders to open positions on either side of the trade easily. This enables traders to benefit from both falling and rising markets.
Foreign exchange forward contract
A forex forward contract is an agreement between the trader and the broker to buy or sell the currency pair at a pre-determined date and price. The forward price is calculated by considering the current spot price of the currency pair and a risk-free interest rate.
The forex forward contract enables hedging by protecting traders against future price volatility and movements. It enables them to fix the rate at which they want to buy or sell the currency pair at a future date.
For example, suppose you are an American exporter exporting a product to India. In that case, you can limit the exchange rate risks and lock in the current exchange rate between USD/INR by entering into a forex forward contract. Hereon, any adverse shift in the exchange rate of USD/INR will not affect you due to the already hedged forex position.
How to get out of a hedge forex position
Exiting a forex position, also called de-hedging, is opposite to a forex hedge strategy that occurs when you get out of a position that you originally opened as a hedge to trade a currency pair. You can decide to de-hedge a trade for many reasons like reducing hedging costs, changing market perspective, exiting the original position, etc.
You can de-hedge your trade by buying back the currency pair if you expect a bullish market reversal or by selling the currency pairs immediately in case of an expected bearish market reversal.
Steps wise guide: how to hedge a forex trade
- Open a forex account to start trading and hedge the risk associated with forex trading.
- Choose the currency pair you wish to trade after studying the different currencies, their charts and respective economic situations.
- Determine the right forex hedging strategy that will help you minimize your losses and protect your profits.
- Apply the forex hedging strategy from either the four fx hedging strategies mentioned above or a strategy of your own and keep up to date with the international news and announcements.
- Define entry and exit positions and open a trade position with your chosen currency pair.
- Use further risk management forex hedging techniques like stop-loss along with hedging strategies to rest assured that your trade positions help you gain profit.
Hedge your forex position today to minimize losses
When you hedge a position, you mitigate potential market risks and losses that arise from market volatility. This helps you protect your existing profits and add on to them. With Blueberry, you can choose from a variety of hedging strategies and experience seamless trading.
Sign up for a Blueberry live trading account or try a demo account.
Frequently Asked Questions
What is a spot hedge?
Spot hedge is a way to hedge a forex position through a contract that enables traders to buy or sell forex with immediate settlement.
How to hedge a trade?
A trade can be hedged by opening a position that is opposite to the current open position. So, if you have a long open position, you hedge by opening a short position. Whereas, if you have a short current open position, you hedge by opening a long position.
What is a hedge in Forex?
Hedge in forex is a way to reduce market risks if the market starts trading against your preferred direction. This means, if you have a long forex position and the market starts falling, a short hedged position will help you cover the losses. Whereas, if you have a short position and markets start rising, a long hedged position will protect you against the losses.