Forex trading carries a certain amount of risk. Even if you study the market, conduct your own technical analysisand enter the market at what you believe is the optimal time, nothing is guaranteed. However, thanks to something known as forex hedging, you can protect trades against a certain amount of risk. To explain what this means, here’s our beginner's guide to forex hedging strategies.
What is hedging?
Hedging is where you hold two positions simultaneously in an effort to reduce your losses. The positions you hold have to contrast in a certain way. For example, if you hold a short on a currency pair (i.e. you think its value will decrease), you can open a long position (i.e. you think it will increase in value) as a hedge.
So, in this example, you stand to make money if the short position succeeds, or if the long position succeeds. Thus, you’ve successfully hedged one position against another to offset any potential losses.
Now, what’s important to state from the outset is that hedging won’t protect you from all losses. This means you won’t be able to protect 100% of your investment in either direction. However, what you can do is protect against certain outcomes.
Therefore, you shouldn’t see hedging in forexas a way of guaranteeing a profit or removing all risk. It can reduce certain potential risks in some situations, but it can’t turn forex trading into a risk-free activity. Risk is an inherent part of trading in all of its forms. Therefore, it’s impossible to eliminate it with hedging or any other trading strategy.
How do you hedge in forex?
Hedging in forex is mainly used as a risk-management tool that can help mitigate short-term market movements. There are ways to hedge when you’re trading forex. However, this strategy can be broadly broken down in two ways:
Perfect hedge
A perfect hedge is where you hold a short and long position on the same currency pair. So, let’s say you hold a long position on USD/EUR. This means you believe the value of this currency pair will increase and, therefore, you’re willing to hold it for an extended period.
However, let’s say there are some political events in America that make you wonder if there may be some volatility in the short or medium term. This volatility could essentially cause the value of USD/EUR to drop, so, instead of closing your long position, you open a short position. This means you’re simultaneously buying and selling the same currency pair.
As such, you hold a correct position if the value of USD/EUR increases or decreases. That makes it a perfect hedge because you can’t lose either way.
However, that doesn’t make this a risk-free strategy because by eliminating the chance you’ll lose money, you’re also eliminating your chance of making a profit. This is because the money you make from one position is cancelled out by the money you lose from the opposing position. Therefore, it’s not a risk-free strategy.
Forex traders who want to maintain a long position but protect themselves against short-term volatility will only use a perfect hedge for a certain period. Once the market appears to be moving into a favourable position, traders will close their short positions.
Imperfect hedge
An imperfect hedge in forex trading is where you use put options contracts to offset an existing position. This may not always be possible via your trading platform, but forex optionsare available at Saxo Bank.
Forex options are derivatives based on underlying currency pairs. There are two main types of forex options: vanilla and SPOT (single payment option trading). These are options that give investors the right to buy (a call option) or sell (put option) a particular currency at a pre-set price at an execution date, as defined by the contract.
An important caveat with options contracts is that they give investors the right to buy or sell, but there is no obligation to exercise that right. You have the “option” to fulfil the contract or not. So, by taking out a vanilla option, an investor can say how much of a particular currency pair they want to buy/sell, the price they want to pay and on the date they want to fulfil their order.
This order is placed via your account. The buy/seller then comes back with a quote premium. Assuming the investor accepts, the options contract is started. They hold a buy/sell position on a currency pair without actually owning the underlying asset.
Forex options example
So, let’s say you hold a long position on JPY/USD. This means you own the underlying asset and you’re holding it because you believe its value will increase. You want to protect against a certain amount of loss in the short-term by using forex options. You, therefore, take out a put option on JPY/USD. If the value of JPY/USD falls, you’ll make money on your put option. If it increases, you’ll lose money on the put option but make a profit on your long position.
Forex options and imperfect hedging summary
We know this is complicated, so here’s a summary of imperfect hedging using forex options:
- Forex options are virtual contracts that give you the right to buy or sell a currency pair at a later date. You don’t have to fulfil this contract, but you’re purchasing the right to make your desired move in the future.
- Options contracts can buy (call option) or sell (put option). To buy means you’re taking a long position. To sell means you’re taking a short position.
- Options contracts are derivatives, which means you’re not purchasing the underlying asset which, in this case, are currency pairs. Instead, you’re paying for the right to make a move (buy or sell) a currency pair.
- You can have an options contract while holding another position.
- These hedges are known as imperfect because you won’t cancel out 100% of your losses on either side. Still, forex traders use this strategy because it gives you scope to limit your losses while still making a profit, depending on the investments you make.
Forex Hedging Strategies
So, the two main forex hedging strategies are perfect and imperfect. To quickly recap, these two strategies are:
Perfect hedging
Also known as direct hedging, this strategy requires you to open long and short positions on the same currency pair. The net profit is zero because your losses will cancel out your profits. However, when used as a short-term strategy, it can be a way to protect long positions during times of volatility.
*Perfect hedging isn’t always available, so check that it’s possible before opening a position.
Imperfect hedging
This strategy requires you to hold a position on a currency pair. You then take out an options contract in the opposite direction. This strategy won’t cancel out all of your profits, but the upside is that it leaves you with room to make a profit (although less than you’d make with a single position).
The final forex hedging strategy you can try is by taking out positions on multiple currency pairs. The aim here is to hold two currency pairs that are closely linked. For example, you can hold a long position on EUR/USD and a short position on GBP/USD.
With this forex hedging strategy, you’re taking two opposing positions. Even though these positions aren’t on the same currency pair, they both include USD. Therefore, what you’re doing in this scenario is mitigating the risk of holding USD. So, if something happens in the US and you feel it will hurt the value of the USD, you could have two positions on the USD using these two currency pairs.
The risks of forex hedging
Hedging doesn’t eliminate all risk and, in situations where it does, your net profit will be zero. This means you can’t use forex hedging to guarantee a profit. Even in situations where you try your best to eliminate your risk and end with a net profit of zero, you may have to pay trading fees, and in that case you’d actually lose money with a perfect hedge.
Forex hedging strategies can also be difficult to understand and implement, particularly if you’re a novice trader. This disadvantage becomes even more pronounced when you get into forex options. Finally, risk and rewards are closely correlated with each other. So, if you make money on one position, you’ll lose just as much on the other.
That makes hedging a useful tool in the short-term but not as effective in the long-term. For long-term investing may make more profit holding a successful single position, compared to a successful hedged position. These are all important considerations.
Forex hedging strategies are useful and they can help you protect long positions during times of short-term volatility. However, forex hedging shouldn’t be seen as an easy way to make guaranteed profits and eliminate all of your risk in the long-term.
