What is Hedging in Forex?
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Hedging as it applies to the forex market and trading, at its most basic form, is a strategy to protect you from losing big in a certain market position. There are many types of hedge that move from the very simple, to the more complex if you are an advanced trader, but the premise is the same. To protect your position in one currency pair by placing a trade within that same market in the opposite direction.
Fundamentals of Hedging
The first point to note is that hedging is not always permitted by all brokers. Therefore, you should check their policy first. As mentioned, the majority of traders who engage in hedging are doing so to provide themselves with a form of protection in the event of adverse market changes. By nature, hedging is particularly common in times of market volatility when the movement is quite unpredictable.
Hedging in the forex market is also more common than in many others. This is often due to the fact that the forex market can be seen as slightly more volatile than many others that are traded. As a forex trader, there are several types of hedge that you can place to protect your position in the market.
Forex Hedging Strategies
While there are a range of hedging strategies available that vary in complexity, here we will outline some of the most common you can utilize depending on your broker policy and level of experience.
Simple Forex Hedging
This strategy is also known as direct hedging. It is one of the most widely used, and easy to understand hedging strategies. Direct hedging occurs when you open a position to buy (or go long) on one currency pair. You then open the same position to sell that currency pair (short).
There may be a number of reasons for doing this, but in any case, a few things happen. You now have two open positions in exactly the opposite direction. Although you do not make a profit on the actual hedge itself, it does allow you to keep your original position. This means you do not have to close your original position for a loss, and can instead start to make money through your short position. Maintaining the original position also means you could again profit if the market trend reverses.
Multiple Currency Hedging
Moving into one of the more complex hedging strategies. If you are trading in multiple currency pairs, then this strategy could be effective to a certain extent for you. Multiple currency hedging takes place when you but a long position, and a counteracting short position in one of those currencies.
For example, you may take a long position in the GBP/USD market, and a short position in the USD/JPY market. In this example, you are protected against your USD exposure to a high degree. This strategy though does not cover movements in the other currencies you are exposed to though. In these cases, if the JPY, or GBP were to fluctuate, you would still be exposed.
A variation of this strategy also sees traders take long and short positions in currency pairs that are positively correlated, meaning that if one currency pair goes down, the other will go up. Such an example of these positive correlated pairs may be the GBP/USD, and EUR/USD. So, if you hold a buying position in one, and selling position in the other, in theory, they should offset. Still though, this is not as exact a strategy as a simple direct hedge.
Forex Options Hedging
An option in forex is an agreement to exchange at a specific price in the future. It is a common instrument used by forex traders who wish to hedge their position. Again, this is referred to as something of an imperfect hedge since it can still result in some losses for you as a trader.
Using an example of how you may buy a forex option to hedge your risk, consider the following:
You have gone long on the EUR/USD at $1.08 expecting the pair to go higher. You are now concerned though that it may fall further on the release of economic data coming in the next few days. In order to mitigate this risk, you may but a put option with a strike price at something like $1.07 on the pair, and an expiration date of the option at some point beyond the data release.
If the pair then does go lower, the trader is paid out on their option based on the contract conditions set. If the news does not materialize, and the pair continues to go higher, then the trader can continue to hold their long position and will have only lost the premium set out in the option contract.
Who Hedges Forex and is it Worth It?
While only you as a trader can make the decision on whether hedging is worth it, the benefit of engaging one of the strategies mentioned here is that you do limit at least some of your exposure in the markets you are trading. Timed right, it can also put you in a more profitable position.
The question of who hedges in forex is more complex, but generally speaking, as long as the forex broker you are trading with allows hedging, then there is nothing to stop you from doing it. It is important that you understand why you are hedging and how you want the market to react but beyond that, almost all levels of trader can get involved with at least some of the strategies above.
Forex Hedging Fees and Costs
There are no direct fees related to forex hedging, but depending on your broker, you may have to pay a commission or spread on the market you are trading. This, as well as any other fees like a swap-fee if you are keeping the position open, are some other important things to factor into your calculations when determining if you should try hedging in forex.
Anthony is a financial journalist and business advisor with several years’ experience writing for some of the most well-known sites in the Forex world. A keen trader turned industry writer, he is currently based in Shanghai with a finger on the pulse of Asia’s biggest markets.