Hedging in forex is a short-term protection measure used in times of uncertainty such as when market conditions are volatile, or when investor confidence is affected by breaking news, natural disasters and the like. Forex hedging can be done in several ways. One of them being, Direct Hedging which involves opening a second position on the same pair a trader already has an open position on.
Basically here, a trader would have a long position on AUD/JPY and simultaneously go short on AUD/JPY. This hedging move is made in the hopes of offsetting any potential risk on an asset they have invested in from anticipated market upsets.
Surely, even a new trader has heard of the concept of minimising and managing risks. Hedging in forex is just that: a form of risk management, but especially as a quick protection measure or fallback when thinking on your feet is needed.
Although, a trader new to hedging should be aware of the fact that some hedging methods are illegal in certain countries .i.e., United States (US). In the case of the US, Direct Hedging is not allowed because it is seen as more beneficial to the broker than the trader. In other words, the ban implementation was done to protect traders.
Forex Hedging as a Short-Term Recourse
The two basic forex hedging strategies are the Perfect Hedge and the Imperfect Hedge. The former is used more for protection against high market volatility. Meanwhile, the latter is used to offset some gain and loss but not to totally eliminate risk.
- Perfect Hedge
The opportunity for the perfect hedge is created when the correlation between two positions that a hedger takes is 100% inverse. This opportunity is hard to come by because it’s uncommon for the gain and loss of two positions to be perfectly equal.
In reality though, there isn’t that perfect hedge that wipes out all risks. Rather a perfect hedge is one that is seen to have the best possible options for offsetting two opposing positions. The common types of perfect hedges are the short hedge and the long hedge.
Short Hedge
An example of a short hedge is when a hedger goes short on a futures contract. This type of hedge is made to protect from losses using assets that are to be sold in the future, or taken by a hedger who foresees that the asset value will depreciate.
Long Hedge
A long hedge is just the opposite whereby a hedger goes long on a futures contract. Here, the hedger protects themselves from loss pre-emptively using an asset that’s expected to be bought in the future or if they expect asset value to appreciate.
- Imperfect Hedge
Long Put Options
When trading forex, an imperfect hedge is a strategy that gives partial protection to a trader’s investment. This type of hedging is executed through the purchase of forex options. By buying either put options or call options, a trader can protect their position depending on if they had gone long or short.
However, it’s important to take note that purchasing options require an initial fee or a premium. Therefore, although an imperfect hedge offers some risk mitigation benefits, it does come with a price which should be accounted for in a trader’s attempt at cutting losses.
Consider how put options contracts give a trader the option to sell a currency pair at a certain strike price, otherwise known as a grant price, on or before an expiration date. This option, without any obligation on the trader to sell, allows the trader to cut losses made on a trade. The purchase of put options are for traders in a long position who at first felt bullish about the prospect of their position appreciating in value, but later due to some reason, feels their position might take on a downtrend movement.
Now, with the second position (the long put options contract) in place, the trader can offset their potential losses on their first open long position, partially, if the downtrend does materialise as predicted. Conversely, if the price stays the same or increases, the trader can choose to hold on to the first position or liquidate.
Short Call Options
The same can be said for traders in a short position when trading in forex. Short call options give traders or hedgers the option, without the obligation, to sell a currency pair. The strike price and expiration date of the call options contract when chosen strategically, can protect a trade from losses.
In this instance, a hedger in a short position who foresees that their position might increase in price (contrary to their initial assessment), could open a second position on a short call options contract.
Let’s assume the hedger chooses a strike price that is not too high from the price they bought their first short position on. This way the hedger could prevent losses from being too great. At least not greater than if they didn’t place the hedge at all.
Why Traders Hedge in Forex?
It’s easy to see how the forex market might be a trader’s playground in the world of trading. It is after all the largest financial market in the world, but also highly volatile. All the more reason then for traders to turn into savvy hedgers. To hedge or not to hedge, is a personal choice. Depending on how hedging is utilised as a trading strategy, it can either set a trader up for failure or be a failure that sets them up for later success.
There are many factors that could spur traders to start hedging, such as currency demand and supply change, political events like a surprise election and more. Some likely scenarios where a trader would consider hedging are shown below:
- Currency and Politics – Taking the GBP/USD pair as an example; let’s look at what would happen in a hypothetical scenario where there’s a sudden election in Great Britain. A likely change of political candidate to one seen as having fiscal acumen might cause an increase in demand for the Pound. This in turn would increase its value in the forex market. A trader who is short on GBP/USD would worry about the likelihood of the Pound’s rise in price as they initially thought it’s value would drop. The forex hedging strategy they could make is a long put options contract.
Placing an order on a long put options contract allows a trader to hedge within a shorter timeframe to protect against a possible strengthening of the Pound. With a strike price where the asset pair price is pre-determined, it would be easier for a trader to exit their second position for offsetting the loss that could be caused by the sudden election on their first position.
This type of imperfect hedge would be easier to pull off instead of a direct hedge. The latter would be if the trader were to go long on the same asset: GBP/USD pair, for the same price. This perfect hedge would be more challenging to execute due to market volatility and the requirement for precise timing on exiting the market at the right price. - Currency and Natural Disaster – In another imagined scenario, a trader might go long on USD/JPY. Knowing the quote currency’s (Yen) history of earthquakes and tsunamis, among many natural disasters, the trader intends to profit from the strengthening of the Buck or USD against the Yen after it is reported in the news that a low magnitude earthquake just happened in Osaka. However, earthquakes are a common occurrence in Japan and the trader is unsure how the Yen will be impacted by the news. The trader also intends to trade this long position, medium-term.
With a direct hedge, the trader opens a second position opposed to their first position (long on USD/JPY). So, the second position would be short on USD/JPY. This way, the trader gets to keep the first position no matter which way the market direction goes. For instance, if the USD/JPY value indeed decreases, then the trader would just close the second position, allowing the trader to keep the first position open. Without the second position, the trader would have been forced to close the first position and accept a loss.
Although a direct hedge amounts to net zero profit, the trader in this case, still managed to prevent their first position from being hit by a major loss. Instead, the trader gets to keep the first position open, continuing to ride the trend for a bit before closing out the trade at a profitable time.
The Good and Bad in Forex Hedging
Hedging is a sure shot way of managing risks of a portfolio. For a forex trader to hedge effectively, it’s important that they know the advantages and disadvantages of hedging.
The Good
- Market Resilience
Allows traders to keep positions open longer for moderate to long-term investments. Hedge positions keep losses incurred along the way at a minimum, allowing traders to be more adaptable and resilient to market volatility. - Overall Risk Management
As the saying goes, hedging your bets is to spread out one’s losses. By doing so, the overall losses of a trader’s portfolio are reduced and its risk to exposure lessened. - Manage Expectations
Since hedging can be executed through derivatives, the pre-set dates and expiration dates avail traders in timing their strategies as rightly as possible. By being able to control price and timing to an extent, traders get to offset their losses against gains.
The Bad
- Steep Learning Curve for Beginners
Hedging is a complicated process and for any beginner to hedge their position, the knowledge required could be demotivating. The complexity involved in hedging can be a deterrent to a beginner from getting off to a good start in their trading career. - Not Cost-Efficient
For each hedging position that is opened, a fee or premium is charged. Strategies that involve opening multiple currency pairs can mean higher hedging cost vs the overall potential profit. The hedging cost can also surpass the losses minimised. - Takes Away from Profit
Hedging takes away from profit potential. Over hedging can reduce a trader’s opportunity to trade with the trend when they target a certain exit point for their positions. Focusing on a certain price for closing a position at the expense of profit potential, limits trading profitability.
Hedging your Bets in Forex
Hedging in forex definitely protects a trader’s portfolio but with the numerous possible ways to hedge, a trader needs more than maverick moves and adeptness. A forex specialised broker would be ideal, such as ZFX which includes diverse asset types in the financial instruments that they provide. Brokers that facilitate trading with several account types, different derivatives, and optimal leverage to cater to all forex traders are best. Specialised brokers such as these often come with relevant trading tools and support for forex traders interested in honing their skills and delving deep into the world of forex trading.
FAQs
1. What is hedging in forex with example?
An example of a short hedge is when a hedger goes short on a futures contract. This type of hedge is made to protect from losses using assets that are to be sold in the future, or taken by a hedger who foresees that the asset value will depreciate.
A long hedge is just the opposite whereby a hedger goes long on a futures contract. Here, the hedger protects themselves from loss pre-emptively using an asset that’s expected to be bought in the future or if they expect asset value to appreciate.
2. How do you hedge against forex?
With a direct hedge, the trader opens a second position opposed to their first position (long on USD/JPY). So, the second position would be short on USD/JPY. This way, the trader gets to keep the first position no matter which way the market direction goes. For instance, if the USD/JPY value indeed decreases, then the trader would just close the second position, allowing the trader to keep the first position open. Without the second position, the trader would have been forced to close the first position and accept a loss.
3. Is hedging a good strategy in forex?
Hedging is a sure shot way of managing risks of a portfolio. For a forex trader to hedge effectively, it’s important that they know the advantages and disadvantages of hedging.
Pro – It allows traders to keep positions open longer for moderate to long-term investments. Hedge positions keep losses incurred along the way at a minimum, allowing traders to be more adaptable and resilient to market volatility.
Con – Hedging is a complicated process and for any beginner to hedge their position, the knowledge required could be demotivating. The complexity involved in hedging can be a deterrent to a beginner from getting off to a good start in their trading career | Hedging takes away from profit potential. Over hedging can reduce a trader’s opportunity to trade with the trend when they target a certain exit point for their positions. Focusing on a certain price for closing a position at the expense of profit potential, limits trading profitability.
4. Is hedging illegal in forex?
Some hedging methods are illegal in certain countries .i.e., United States (US). In the case of the US, Direct Hedging is not allowed because it is seen as more beneficial to the broker than the trader. In other words, the ban implementation was done to protect traders.
