What is Forex Hedging and How Do I Use It?
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This article will provide you with everything you need to know about hedging, as well as, what is hedging in Forex?, an example of a Forex hedging strategy, an explanation of the 'Hold Forex Strategy' and more!
What is 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 kind 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.
A US multinational will accrue revenue in many different currencies, but will report their earnings and pay out dividends in US dollars. Companies will hedge in various markets, to offset the business risks posed by these unwanted exposures. For example, the airline might choose to hedge by buying futures contracts in crude oil. This would protect the company against the risk of increased costs from a rise in the price of oil.
There's more: crude oil is priced internationally in US dollars. When the futures contracts expire, the company would take physical delivery of the oil and pay in US dollars. If we are talking about a non-US company, this would pose a currency risk. Therefore, there's a strong likelihood that the company would also choose to hedge its risk in foreign exchange.
To do so, the company would sell its native currency to buy US dollars, and thereby cover its dollar exposure from the crude oil position. It's not just companies that take part in Forex hedging though. As an individual, you may find yourself in a position where foreign exchange hedging might be an attractive option.
What is Hedging in Forex? Hedge and Hold Forex Strategy Explained
Hedging can be performed in a number of different ways within Forex. You can partially hedge, 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.
But, we're going to concentrate on using the spot FX market. You might find yourself hedging against foreign exchange risk, if you own an overseas asset. For example, let's say you live in the UK and invested in Nintendo shares before the success of Pokemon Go, and you subsequently profited majorly after the fact.
And let's say that your unrealised profit was JPY 1,000,000. Now, if you wanted to draw a line under that profit: you could sell your shares, and then convert the Yen back into Sterling. At a GBP/JPY rate of 137.38, your profit would be 1,000,000/137.38 = £7,279 (ignoring transaction costs). Here's an example of how hedging is performed with Admiral Markets:
Source: MetaTrader 4 Supreme Edition - Mini Terminal - Hedging
Now, continuing with our scenario - what if you wanted to keep hold of your shares in the hope of running your profits further? In such a scenario, you are keeping your long exposure to Nintendo: but you also have exposure to GBP/JPY. What does this mean?
If the Yen weakens, it will cut into your profit. You might be happy to run such an exposure, hoping to make additional profit from the Yen strengthening. But if you were only interested in having exposure to the asset in question, without the additional FX exposure - you might purchase GBP/JPY as a hedge. By doing so, you are hedging against foreign exchange risk. How much should you hedge?
This depends on whether you want to entirely remove your foreign exchange risk. If you wanted to hedge the whole position, you would need to buy £7,279 worth of Yen. One contract of GBP/JPY is £100,000. You would therefore need to buy 7,279/100,000 = 0.07279 contracts. If the Yen now weakens against the Pound, you will profit on your GBP/JPY trade as the exchange rate rises.
The amount you make from your foreign exchange risk hedging should offset the negative impact of the weaker Yen on your equity trade. In reality, there is the potential complication that the currency risk fluctuates as the value of the shares changes. Consequently, you would need to alter how much was hedged, as the value of the shares changed. Now let's consider someone who is purely an FX trader:
How Does the Forex Hedge and Hold Strategy Work?
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. But, 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 the Brexit vote.
Your positions are:
- Short one lot EUR/GBP
- Short two lots of USD/CHF
- Long one lot of GBP/CHF.
Overall you are happy with these as long-term positions, but you are worried about the potential for volatility in GBP going into the Brexit vote. 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.
Source: MetaTrader 4 Supreme Edition - GBPUSD Daily Chart - Data Range: 10 Feb, 2016 - 27 Jul, 2016 - Please Note: Past performance does not indicate future results, nor is it a reliable indicator of future performance.
The chart above shows just how sharply the GBP/USD currency pair moved in the wake of the Brexit vote back in 2016. The short position taken in GBP/USD as a hedge would have saved you from a big loss. 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 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. The Correlation Matrix that comes bundled with the MetaTrader 4 Supreme Edition plugin allows you to view the correlation between different currency pairs.
Source: MetaTrader 4 Supreme Edition - Correlation Matrix
If you find a currency pair that is strongly correlated with another, it is possible to construct a position that is largely market neutral. For example, let's say you have a long position in GBP/USD. You see that USD/CAD has a strong negative correlation to GBP/USD (as shown in the image above). Buying USD/CAD should in theory, serve to hedge some of your exposure - providing the correlation holds.
But because they are not 100% inversely correlated: it would not provide a total hedge if you dealt in an equivalent size in both pairs. The concept of combining correlated positions in order to offset risk is where Forex hedge funds originally got their name. If you are interested in trying to construct a market neutral strategy, you can experiment risk free with our Demo Trading Account, where you can trade with real information, with virtual funds, without putting your capital at risk.
Final Words About Forex Currency Hedging
Hedging is a way of avoiding risk, but it comes at a cost. There are transactional costs involved of course, but hedging can also dent your profit. A hedge inherently reduces your exposure. This reduces your losses if the market moves adversely. But if the market moves in your favour, you make less than you would have made without the hedge.
Bear in mind that hedging:
- Is not a magic trick that guarantees you money no matter what the market does
- Is a way of limiting the potential damage of an adverse price fluctuation in the future
Sometimes simply closing out or reducing an open position is the best way to proceed. At other times, you may find a hedge or a partial hedge, to be the most convenient move. Do whatever best suits your risk attitude. If you would like to learn more about Forex hedging, and would like to find out what other types of Forex hedging strategies exist, why not read our related article?: How to Use a Forex Hedging Strategy to Look for Lower-risk Profits
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.