What is Forex Hedging and How Do I Use It?
Have you ever wondered what hedging is in Forex? Well, look no further, as this article will teach you everything you need to know about hedging, including an example of a Forex hedging strategy and an explanation behind the 'Hold Forex Strategy,' amongs other things.
Table of Contents
Hedging: An Introduction
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.
- 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.
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How to Hedge in Forex: Let's See
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.
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).
Here's an example of how hedging is performed with Admirals:
Continuing with our scenario, what if you wanted to keep your shares in the hopes of increasing your profits further? In such a scenario, you could maintain your long exposure to Nintendo while also having exposure to GBP/JPY. What exactly does this mean?
If the Yen falls in value, your profit will be reduced. You might be content to hold such an exposure, hoping to profit from the Yen's strengthening. However, if you were only interested in the asset in question, without the additional FX exposure, you could buy GBP/JPY as a hedge. You are hedging against foreign exchange risk by doing so. What is the appropriate amount to 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 Forex 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:
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. 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 a volatile market event.
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 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.
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.
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 trading strategies, you can experiment and trade risk-free, with real live information, virtual funds and without putting your capital at risk. For more information, click the banner below:
Hedging With a Robot
Forex hedging with automated trading tools, or robots, can be advantageous to some traders for obvious reasons. Once set up, they do a lot of the work for you.
A forex hedging robot is designed around the idea of hedging, which is based on opening many additional positions and buying and selling at the same time combined with trend analysis. This is all done in order to protect yourself against sudden and unexpected market movements. The robots do just that, with the aim of keeping your floating amount positive. Keep in mind that you will have multiple positions open at once so you or your broker can be sure you are following FIFO rules, which us to our next question:
Is Hedging Legal?
Hedging with Forex trading is illegal in the US. To be clear, not every form of hedging is outlawed in the US, but the focus in the law is on the buying and selling of the same currency pair at the same or different strike prices. As such, the CFTC has established trading restrictions for Forex traders.
However, forex hedging is not illegal by a number brokers around the world including many in the EU, Asia, and Australia.
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 article, How to Use a Forex Hedging Strategy to Look for Lower-risk Profits.
Finally, if you are looking to boost your trading strategies further, or want to refresh your basics, feel free to join one of our free webinars below:
Other articles you may find interesting:
- Overview of the Best MT5 Indicators
- Use MetaTrader Like a Pro With MT4 & MT5 Shortcuts
- Crude Oil CFDs: How To Trade Crude Oil CFDs
Frequently Asked Questions
What is hedging in Forex?
Hedging in forex is a risk management strategy where traders use financial instruments to offset potential losses resulting from adverse price movements in the foreign exchange market.
How does hedging work in Forex trading?
Hedging involves opening a trade or trades opposite in direction to an existing position. This helps mitigate risk by balancing potential losses against gains due to market fluctuations.
What are common methods of hedging in Forex?
Common methods of hedging in forex include using forward contracts, options, futures contracts, and spot contracts. These tools allow traders to protect their positions from unfavorable exchange rate movements.
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