Investors of all stripes use hedging as a strategy to protect one position from adverse price changes. As a rule, hedging involves opening a second position, which is likely to have a negative correlation with the main asset, that is, if the price of the main asset makes an unfavorable movement, the second position will experience a complementary and opposite movement that compensates for these losses.
In Forex trading, investors can use the second pair as a hedge for an existing position that they do not want to close. Although hedging reduces risk at the expense of profit, it can be a valuable tool to protect profits and prevent losses in Forex trading.
Basics of Forex Hedging
An insurance transaction in Forex trading implies the invention of a view according to one monetary two, which counteracts the permissible changes according to the other monetary two. If we assume that the scales of these positions are similar, and the value movements backward are correlated, then the value changes in these positions have all chances to mutually compensate each other, as long as these two are energetic.
In spite of the fact that this also eliminates the possible income in the given interval, however it limits the danger of losses.
A simple configuration of such hedging is considered a direct insurance transaction, in which traders disclose the transaction in the acquisition as well as the transaction in the realization according to one as well as the same monetary two, in order to save the acquired income or avoid subsequent losses. Traders have all chances to apply and also the most difficult combination to hedging, based on popular correlations among 2 monetary pairs.
What does hedging mean in forex?
Hedging in the Forex market is an activity to reduce or prevent losses arising as a result of unforeseen events in the foreign exchange market. Hedging strategies can be applied in all financial markets, but, in particular, in Forex, they are the most common, given the number of influencing factors.
The Forex market is the largest and most liquid financial market in the world, and since more than 330 Forex pairs are available on our trading platform, there is no shortage of foreign currencies for trading. Therefore, traders have created various hedging strategies in the Forex market in order to minimize the level of currency risk arising from changes in various economic indicators.
To hedge currency risk, forex brokers offer derivative financial instruments, which, as a rule, are over-the-counter products. This means that they are not traded on a centralized exchange, and in some cases, derivative financial instruments may be modified at some point during the entire term of the contract. However, over-the-counter trading is not regulated and, as a rule, is considered less secure than trading through an exchange, so we recommend that our traders have the appropriate level of knowledge before opening positions.
Hedge and Hold Strategy in Forex Hedging
Hedging is risk reduction to protect against unwanted price changes. Obviously, the easiest way to reduce risk is to reduce or close positions. However, there are cases when only temporary or partial risk reduction is required. Depending on the circumstances, hedging may be more convenient than simply closing a position. Let’s take another example – let’s assume that you have several positions on foreign exchange transactions in the run-up to the Brexit vote.
Your positions are as follows:
- short one lot EUR/GBP
- Short two lots USD/CHF
- Long lot in GBP/CHF.
In general, you are happy with these long-term positions, but you are concerned about the potential volatility of the British pound in the run-up to the Brexit vote. Instead of exiting two positions on GBP, you decided to hedge. To do this, you open an additional position by selling GBP/USD. This reduces your exposure to GBP risk as you sell pounds and buy US dollars, while your existing positions are long on GBP and short on US dollars.
You can sell two lots of GBP/USD to fully hedge your position on sterling, which will also lead to the additional effect of eliminating the risk on the US dollar. Alternatively, you can hedge a smaller amount than this, depending on your attitude to risk.
The chart above shows how sharply the GBP/USD pair has changed since the Brexit vote in 2016. A short position taken in the GBP/USD pair as a hedge would save you from big losses. Please note that you could also trade another currency pair: the key aspect is a short position on sterling, since it is the volatility of sterling that you wanted to avoid.
As an example, the GBP/USD pair is used here, since it conveniently compensates for the existing long position on the dollar. Please note that this, as a consequence, has an additional impact on your position on the US dollar. Another, slightly less direct way of hedging currency risks is to conclude a transaction with a correlating currency pair. The correlation matrix supplied with the MetaTrader 4 Supreme Edition plugin allows you to view the correlation between different currency pairs.
If you find a currency pair that strongly correlates with another, then you can build a position that will be largely neutral with respect to the market. For example, let’s say you have a long position in the GBP/USD pair. You can see that the USD/CAD pair has a strong negative correlation with the GBP/USD pair (as shown in the figure above). Buying USD/CAD should, in theory, hedge part of your position – provided that the correlation persists.
How to hedge currency risk?
For this purpose, in order to hedge monetary dangers, it is usually necessary to consult the degree of knowledge of those who understand the dangers of trading in such an unstable trade. But also young traders have all chances to master the procedure of trading in Forex trading, in case they become radical and also realize how the exchange functions.
In order to prepare for this, check out our step-by-step guide to Forex trading for beginners. I also advise our customers to keep an eye on our news and opinion section, where our experts often publish new announcements as well as announcements. In this case, this can help you to research and also anticipate movements in Forex trading.
Forex hedging example
Let’s take a sample of the socio-political situation, for example, the sale of elections in the United States of America. For this purpose, I can use the strategy of interconnected hedging in Forex trading, which implies the selection of 2 monetary forces directly combined among themselves, for example EUR/USD and GBP/USD.
If you want to hedge your own risks according to the United States dollar, you can open a long transaction according to GBP/USD, and a short – according to EUR/USD. This means that in case the buck increases in value according to the relationship to the currency, in this case the long view will give losses, but they will be compensated by the benefit according to the short view. At the same time, if the direction of the dollar in relation to the currency decreases, in this case the hedging policy can help to compensate for the danger according to the short view.
Hedging forex with forwards
Currency forwards are similar to options because they create a contractual agreement to exchange currency at a set price on a future date. Unlike options, there is an obligation to execute a contract upon expiration, either in cash or in physical form.
As in the case of options, hedging with the help of currency forwards allows you to fix the price in advance and thereby insure against any adverse changes in the market.
Forwards are often confused with futures contracts – although they work almost the same, forwards are over-the-counter products, not exchange-traded.
How to hedge currency
- Open an account. You can open a real account and start trading right now. Alternatively, you can practice risk-free hedging techniques on a demo account.
- Select a currency pair. We offer more than 330 currency pairs for trading, including major, minor and exotic crosses. If you want to take advantage of market volatility, it is better to choose a currency for which changes in inflation, interest rates or the country’s GDP are observed.
- Determine the hedging strategy in the Forex market. Regardless of whether it will be one of the four aforementioned strategies or a completely different one, it is necessary to develop a thorough plan with an end goal.
- Follow the news of the Forex market. Trading on news and economic announcements can be a useful strategy for forex traders as the market is constantly changing. Our economic calendar can be customized according to your personal preferences, and all upcoming events that may affect your positions will be marked in it.
- Download our mobile app. You can choose to receive price notifications when your chosen currency pair reaches a certain level or price. You can also receive desktop notifications to take advantage of trading opportunities at the moment.
- Determine the entry and exit points and make a deal. Follow the Forex signals and use the numerous technical indicators available in our platform to build a reliable technical analysis strategy.
- Use proper risk management. We have a number of stop loss and take profit orders that allow us to prevent capital loss as much as possible. You can read more about the types of order execution here.