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 part of doing business.
Companies often gain unwanted exposures 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.
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.
Hedging can be done a number of different ways in 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 have invested in Nintendo shares, sitting on a healthy profit after the success of Pokemon Go.
And let's say that your unrealised profit is 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 done with Admiral Markets.
If you are interested in doing something like this, try it out yourself with
MT4 Supreme Edition.
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 an 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 an exposure to the asset in question without the additional FX exposure - you might buy GBP/JPY as a hedge.
By doing so, you are hedging against foreign exchange risk.
How much should you hedge?
It 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 complication that the currency risk fluctuates as the value of the shares changes.
Consequently, you would need to:
Now let's consider someone who is purely an FX trader.
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:
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:
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.
The chart above shows just how sharply GBP/USD moved in the wake of the Brexit vote.
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 MetaTrader 4 Supreme Edition, 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 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.
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:
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.
Learn more about How to use a Forex hedging strategy to look for lower-risk profits