Forex hedging is a strategy you can use to offset currency exposure risk, with the view of limiting potential losses in the event of an adverse price movement.
In this guide, I discuss some of the best forex hedging strategies for active traders, alongside the pros and cons of this trading system.
Also Consider: My guide to the top forex brokers May 2023
My key takeaways from my guide to forex hedging strategies are:
- Choose a Purpose: To protect against potential currency exchange rate fluctuations and reduce risk.
- Understand the Different Types: Common types include forward contracts, options, and currency swaps.
- Implementation: Hedging strategies can be implemented through various financial instruments, such as contracts or options.
- Timing: Hedging strategies should be implemented before a currency exposure arises or before a potential risk materializes.
- Effectiveness: The effectiveness of a hedging strategy depends on various factors, such as the size and timing of the hedge, the market conditions, and the degree of correlation between the hedge and the underlying exposure.
- Cost: Hedging strategies may involve costs, such as option premiums or bid-ask spreads, which can impact their overall profitability.
How to choose the best forex hedging strategies?
You should first consider what your objectives are when learning about forex hedging.
After all, unlike other forex trading strategies, hedging is not a process that aims to generate profit.
On the contrary, hedging is a risk-management strategy that enables you to reduce your exposure to risk.
- For example, let’s suppose that you have a large long position on GBP/USD, meaning that you believe that the British pound will rise in value against the US dollar.
- However, you have concerns about the UK’s upcoming GDP (Gross Domestic Product) figures for the previous quarter.
- In this scenario, you can enter a hedging position by speculating against the rise of GBP, through an alternative forex pair.
As per the above example, the UK’s GDP report is positive, so the value of the original GBP/USD position could well rise. In turn, the value of the newly entered hedging position may decline.
The result of this is that while you make money through the original position, the hedging order will have resulted in a loss. As such, you have neither made gains nor a loss. This is hedging in its most basic form.
Ultimately, in order to choose the best forex hedge strategy, you will first need to assess what your concerns are regarding an open position, and explore the best way to mitigate the risk through an alternative pair.
The best hedging strategies in forex trading
In this section, I explore some of the best hedging strategies in the forex market.
Read on to find a suitable hedging strategy that best facilitates your risk-management objectives.
FX correlation hedging strategy
The FX correlation system is one of the most widely used hedging strategies for forex traders.
This strategy aims to mitigate the risk of an open position in the forex market by trading against it through a correlated pair. If two or more currencies have a correlated relationship, this means that they often rise and/or fall in tandem.
- For example, the British pound and the euro are two highly correlated currencies, considering that there are close economic ties between the UK and the broader European single market.
- In turn, let’s suppose that you are currently long on EUR and USD.
- You wish to hedge your position to reduce the risk posed by market volatility, and this can be achieved through a correlated pair, such as GBP/USD.
Once a correlated pair has been identified, this forex hedging strategy requires you to place an opposite position.
For example, if you are long on EUR and USD, you could short GBP and USD – and vice versa. As I cover in more detail later, there is always the risk that correlated currency pairs do not move in the direction that you had anticipated.
This means that there is every chance that you lose money on both the original and the hedging trade.
Direct hedging strategy
I found that one of the most popular hedging forex strategies for beginners is to simply open a new position that is opposite to the trade you currently have in place.
This is known as a direct hedging strategy.
- For example, let’s suppose that you currently have a short position on USD/JPY.
- This position means that you believe the US dollar will decline in value against the Japanese yen.
- However, you are concerned that the US dollar might see an increase against the yen if upcoming inflation figures are above expectations.
- In this scenario, the easiest way to hedge against the identified risk is to open a long position on USD/JPY.
- This means that you will have both a long and short position on the same currency pair.
- Hence, any future price movements from the time the hedging strategy is deployed will result in a net gain of zero.
On the one hand, I should note that this forex hedging strategy does not carry the same risk when compared to a system that focuses on correlated forex pairs.
After all, if the price of USD/JPY increases, the hedging trade will make a profit while the original position will make a loss – at equal amounts. And the same again if the opposite happens.
However, some forex brokers do not allow traders to direct hedging on the same currency pair.
Hedging strategies for options
If you have prior experience in trading complex financial instruments like options, this offers another way to hedge your forex position.
For those unaware, forex options enable you to enter a large position without owning the currency lot upfront. In fact, you will only need to pay a small premium to enter the trade, which is often 5-10% of the position size.
When hedging with forex options, the primary concept is that you will be trading against an open position. You will do this with either call or put options, depending on whether you will be going long or short.
- For instance, let’s suppose that you have an open long position on USD/CHF.
- You are concerned that the pair could see a sudden decline to the downside, which will result in a loss.
- To hedge against this concern, you could purchase put options on USD/CHF, which means that you are short-selling the pair.
- On the flip side, if you were originally short on USD/CHF, you would purchase call options.
Either way, the outcome will be the same. That is to say, irrespective of whether USD/CHF rises or falls, your hedging strategy will avoid any gains or losses after the options position is deployed.
Trading with forex options
I should also note that when hedging forex with options, you will need to consider the duration of the contract. This could be anywhere from a day up to 12 months. Crucially, you will need to purchase call or put options with an expiry date that covers your hedging strategies.
For instance, if you are hedging a currency pair because of an upcoming economic event – such as an election or interest rate meeting, the options will still need to be active during and after the respective date.
This will ensure that you have enough time to evaluate the event and ultimately – close the hedging position at an appropriate time.
Risks associated with hedging in forex
The overarching aim when deploying hedging strategies is to reduce your risk exposure to a specific currency pair that is currently being traded.
However, I should make it clear that hedging in itself is not completely free of risk.
In fact, a poorly executed hedging strategy can actually result in a loss.
First and foremost, it is not possible to achieve a completely net-zero result when hedging forex.
After all, forex brokers are in the business of making money – so you will invariably be required to pay fees when entering and exiting a hedging position.
- This will initially include a commission and/or spread on the currency pair.
- For instance, let’s suppose that you are using a 0% commission forex broker that charges a 0.9 pip spread on EUR and USD.
- This means that irrespective of the hedging outcome, you will be required to pay at least 0.9 pips both when entering and exiting the position.
In addition to commissions and/or spreads, you will also need to factor in overnight financing fees. Otherwise referred to as swap fees, this is a charge implemented by brokers when a forex position is kept open overnight.
Hence, the longer your forex hedging position is open, the more you will pay in overnight financing fees.
Deviation from historical correlation
Another risk to consider before hedging your forex positions is that there is no guarantee that identified currency pairs will remain correlated.
For instance, I mentioned earlier that there is a strong correlation between EUR and USD and GBP/USD, due to the close economic ties between the British pound and euro.
In turn, you might be tempted to go short on GBP/USD if you are currently long on EUR and USD – and vice versa.
However, there is every chance that GBP/USD actually rises in value, meaning that your short hedging position would generate a loss.
And, if EUR and USD declines in value, your original long position would also be at a loss. This means that overall, your hedging strategy has not achieved its goal, considering that both positions have declined in value.
Equally however, the opposite could also happen, insofar as both the original and hedging position generate an unexpected profit.
How do I start forex hedging?
There is generally a standardized formula when deploying a forex hedging strategy, which I outline in the sections below.
Step 1: Identify the risk factor
The first step is to identify the risk associated with a forex trading position that is currently open.
- For instance, we will say that you are currently trading EUR and USD.
- As every forex trader should, you keep a firm eye on upcoming economic events that could positively or negatively impact your open position.
- In the coming days, let’s say that Europe’s largest economy – Germany, is due to release its quarterly GDP figures.
This could present a risk for your EUR/USD trade, irrespective of whether you are long or short.
Step 2: Choose a suitable hedging strategy
Once the risk has been identified, the next step is to choose a forex hedging strategy.
- If you are a complete beginner – and your forex broker permits it, then opening an opposite position is arguably the most straightforward option.
- For instance, if you are long on EUR/USD, you will place a short position on the same pair.
Another option is to trade forex pairs that have a strong correlation with EUR/USD, such as GBP/USD. As noted earlier, this does increase the risk factor, as correlated currency pairs won’t always move in tandem.
Experienced hedging strategy forex traders might instead consider hedging the position with forex options, by deploying calls or puts, depending on the original trade and identified risk depending on the market volatility.
Step 3: Apply risk management
All hedging strategies should apply sensible risk management practices.
At the forefront of this is deploying a stop-loss order. This is especially important if you are hedging with options or correlated currency pairs, as you will always face the risk of additional loss.
- The stop-loss order will effectively instruct your forex broker to close the hedging position if it rises or falls by a certain amount.
- For instance, if the hedging position goes short on EUR/USD, you might enter the stop-loss at 1.5% above this price.
Crucially, you will need to ensure that the stipulated stop-loss amount mirrors that of the original trade.
Otherwise, if your hedging position is closed by the stop-loss order but the original trade is still in play, you will no longer be protecting yourself from the identified risk.
Step 4: Exiting a hedging trade
Once the hedging position has been entered, you will now need to keep an eye on the financial markets.
In this example, you will wait for Germany to release its quarterly GDP figures, and assess how the broader market reacts.
If your hedging strategy was deployed successfully, you will not make any trading gains or losses from the time the position was entered.
After you have anticipated the future direction of your original EUR/USD position, you can then close the hedging trade.
Is forex hedging profitable?
The objective of forex hedging vs just trading forex is not to make a profit, which makes the system completely unique from any other trading strategy.
As I have stressed throughout this guide, hedging is a risk-management tool for limiting potential losses.
In reality, if you are using a forex broker that offers competitive commissions, spreads, and overnight financing fees, then you might consider closing the position instead of hedging.
The reason for this is that you will avoid the additional risk that hedging presents, such as ending up with two losing positions.
In this guide, I have discussed some of the most popular hedging strategies utilized by forex traders with a view to helping you to understand forex hedging.
Becoming proficient in hedging will enable you to trade currencies in a more risk-averse way, not to mention protect yourself from large losses.
Just remember that hedging in itself is not risk-free and there is no simple forex hedging strategy to follow. This is why risk management is just as important when hedging – as it is with any other forex trading strategy.
Forex Hedging Strategies FAQs
When should I use a hedging forex strategy?
You should use a hedging forex strategy if you believe that one of your open forex positions is at risk of moving against you in the near future. This might be because of a core economic event, such as a Federal Reserve interest rate meeting.
Why do some traders who use forex hedging strategies still lose money on a regular basis?
You should remember that although hedging is a risk-management strategy to restrict potential losses, you can still lose money. This will be the case if you are hedging correlating currency pairs that subsequently move in the opposite direction.