Currency hedging is a tactic used to minimize risks by trading financial instruments in opposite directions. Protects an expected or current position by holding open trades in opposite directions, for example, holding a short and a long trade at the same time. A wide range of market participants, including traders, organizations and shareholders, commonly use currency hedging. By using forex hedging correctly, traders who are long-term in a forex currency pair or stay in perspective through trading can protect themselves from any kind of uncertainty.
So, what is currency hedging? Hedging is when traders open a forex trade to offset another that has already been opened. In other words, hedging helps limit losses without using stop-loss strategies. In its most basic form, it protects traders from losing large positions in their market positions.
This article will discuss the principles of forex hedging, the different strategies used and the underlying risks, costs and fees.
Forex Hedging Principles
The first thing every trader should keep in mind is that hedging is not a money making strategy. It is only used to protect traders from losses and not to earn profits. Most hedges aim to eliminate some of the exposure risk rather than all of it. This is because there are certain costs involved in forex that often outweigh the benefits after a point. Additionally, not all brokers allow forex hedging. Therefore, traders should always check the terms on the official website before joining any forex trading platform.
Most forex traders who use hedging do so to protect themselves during adverse market conditions. Also note that hedging is more common in the forex market than in other financial markets. This is because forex is considered more volatile than others.
What is Hedging in Forex Trading?
Let’s take an example to understand what hedging is in forex trading. If a company (with the yen as its domestic currency) is willing to sell its products in US dollars, it can hedge a portion of its transaction by removing the currency right it will gain if the yen appreciates against the USD. If the trades take place without any protection and somehow the USD strengthens or remains flat against the Yen, the company only loses the cost of the options. However, if the USD weakens, the gains from the forex option can potentially offset some of the losses incurred when the funds were received from the sale.
Who Can Hedge in Forex?
The benefit of currency hedging allows investors to limit at least some of their exposure to the market in which they are trading. If used at the right time and in the right way, it can put investors in a more profitable position. We now come to the question, Who hedges forex? To put it mildly, the answer is more subtle but also more complex than one might think. As long as forex brokers allow hedging on their platform, there is no one who can stop a trader from using it.
The majority of traders of all experience levels can hedge forex and use any of the strategies listed below. However, it is important to understand the principles of hedging, why and when it is used and how the market will respond to it in order to benefit from currency hedging.
Forex hedging strategies
There is a wide range of forex hedging strategies that vary in complexity. Some of the most commonly used forex hedging strategies that traders can use depend on their level of experience. Here are the top three strategies used in forex hedging –
Simple Forex Hedging
Simple spot hedging or forex hedging is a widely used and understood strategy that traders can implement when opening a position to go long or buy any forex currency pair. Traders can open the same position to short or sell the particular currency pair. Direct hedging can be done for a number of reasons. Although the net profit from this strategy is zero, traders can keep their original position ready when the market trend reverses. If traders do not hedge the position, closing the trade would involve taking losses. However, if traders decide to hedge, they can make money on the second trade as the market moves against the first.
Multi-currency hedging
Multi-currency hedging is a more complex strategy used when trading multiple currency pairs. This strategy can be effective to a certain level when traders buy a long position and then hedge a short position in one of the currencies. For example, a trader may go long in the USD/GBP market and not long in the JPY/USD market. In such a scenario, they hedge their GBP exposure to a high degree. However, this strategy does not cover movements in other currencies that traders are exposed to. If GBP or JPY fluctuates, they will still be exposed.
Hedging Forex Options
Currency options in forex give holders only the right and not the obligation to trade currency pairs at given prices. Forex options are popular hedging tools as they offer investors the opportunity to minimize exposure while only paying for the cost of the options.
For example, if traders go long AUD/USD, have opened a position at $0.76 and expect a sharp decline, they can hedge the risk with a one-month $0.75 put option. At the time of expiration, if the price of AUD/USD falls below $0.75, they will take a loss on their long position, but their option will be in the money and balance their exposure. However, if the currency pair rises, they can let their options expire and only pay the premium.
Risks of currency hedging strategies
Forex hedging strategies work in a similar way to stop loss orders as they both limit losses. However, forex hedging allows investors to make money from hedged trades if executed correctly. Traders often make a big mistake of viewing forex trading strategies as a way to place equal and opposite trades with those they have already opened. However, that is not how currency hedging works.
The three main methods of hedging in currency trading are futures contracts, spot contracts and currency options. Standard transactions created by traders are called spot contracts. Spot contracts are not the most effective method of currency hedging due to their short delivery period.
A successful strategy requires conducting short and long trades simultaneously in the same currency pair. Hedging is generally used to stop profits or losses during reversals. If the market goes up and traders are short, they may buy to temporarily hold a position until the market moves back in their favor. Many traders have the wrong idea, believing that they are risk free since they are fully hedged. It is not right to let the trade run for weeks or months. Forex strategies can lead to huge losses if traders do not take into account other important factors such as carrying costs.
Overall, every trader should learn how to use forex hedging strategies and went to use them, as it is very likely that you will end up making 2 losing trades instead of one. To ensure if there is an opportunity for forex hedging, traders must rely on different tools for technical analysis. No trader would like to make losses or unsuccessful trades while trading in foreign currencies, and therefore, should always proceed with greater caution and use forex hedging strategies wisely.
Compensation costs and fees
Forex hedging has no direct commissions, but based on the chosen forex broker, traders may have to pay commissions or margins to the financial markets they trade. In addition, other fees may be related to currency hedging, such as the exchange fee for traders who keep their positions open overnight.
It should be noted that the objective of forex hedging is not to make money but to protect trades from losses. Therefore, the cost of hedging cannot be avoided, whether it is the cost of options or lost profits on the unfortunate side of the currency. If the cost of forex hedging becomes too high, traders can disengage or close out of a current hedging position if it is no longer required.