How to Use Hedging Strategy in Forex Trading

Hedging is an important concept in the financial markets allowing investors to maintain their financial health. Hedging is used in almost all types of financial businesses but it has a more specific form in the foreign exchange market.

If you have been trading in forex, you will be familiar with how volatile the forex market can be. This volatility, while throwing up a host of opportunities, increases risk in equal measure. The benefit of using a hedging strategy is that it can help mitigate the loss or limit it to a known amount. In this article, we will analyse the ins and outs of hedging and list the strategies you can implement to protect your funds from price fluctuations.

What Is Hedging in Forex？

Hedging means taking a position in order to offset the risk of future price fluctuations. It is a very common type of financial transaction that companies conduct on a regular basis, as a regular part of conducting business.

Forex hedging is a transaction implemented to protect an existing or anticipated position from an unwanted move in exchange rates. Hedging in the forex market involves a trader investing in multiple currency pairs to minimize the risk by taking a negligible loss or a small profit, irrespective of the market volatility. While there is no sure-fire way to remove risk entirely, forex hedging can help reduce short-term while protecting your long-term profits.

It is important to remember that a hedge is not a money making strategy. A forex hedge is meant to protect from losses, not to make a profit. Moreover, most hedges are intended to remove a portion of the exposure risk rather than all of it, as there are costs to hedging that can outweigh the benefits after a certain point.

How Do Forex Hedging Strategies Work？

There are a vast range of risk management strategies that forex traders can implement to take control of their potential loss, and hedging is among the most popular. Common strategies include simple forex hedging, or more complex systems involving multiple currencies and financial derivatives, such as options. In this article we will discuss the following strategies:

1. Direct FX Hedging Strategy

One direct hedging strategy in Forex is to open both buy and sell position in the same currency pair. For example, if you already had a long position on a currency pair, you might choose to open a short position on the same currency pair – this is known as a direct hedge or a simple forex hedging strategy.

However, the hedging method in forex is deemed to be illegal in the US. The CFTC has implemented several trading restrictions on Forex traders, the primary among them being the ability to hedge a position on the same currency pair.

Luckily, there is one hedging strategy to trade Forex, which is completely lawful and at the same time can be still effective. For example, a trader who opens a long GBP/USD and wants to use hedging strategy can further open a long USD/JPY and a short GBP/JPY positions simultaneously. The upside to this approach is that a trader is using a completely legal method and at the same time is hedging his or her trades from potential losses.

2. Hedging Forex with Correlated Currency Pairs

One of the popular hedging strategies to trade Forex involves the use of highly positively or negatively correlated currency pairs. For example, if the degree of the positive correlation between two pairs is above 90%. This essentially means that those two pairs move in the same direction for at least 90% of the time.

This hedging strategy for Forex traders is also helpful in the sense that the market participants can utilize not only positively but also negatively correlated pairs as well. One example of this would be AUD/USD and USD/CAD.

In this case, a trader can open a long AUD/USD and USD/CAD positions. Because those two pairs mostly move into opposite directions, here also losses in one trade will be offset by the gains made in the second one, so it can still fulfill the role as a viable hedging strategy.

3. Hedging Forex with Options

Foreign currency options are one of the most popular methods of currency hedging. FX options are a form of derivatives products that give the trader the right, but not the obligation, to buy or sell a currency pair at a specified price with an expiration date at some point in the future.

Foe example, if you are long on EUR/USD and has opened your position at $1.2028. But you are expecting a sharp decline and decide to hedge your risk with a put option at $1.2028 with a one-month expiry.

If at the time of expiry the price has fallen below $1.2028, you would have made a loss on your long position but your option would be in the money and balance your exposure. If EUR/USD had risen instead, you could let your option expire and would only pay the premium.

This strategy provides the trader with some protection from shorter term trades. Some commonly used strategies using foreign currency options are the long-term straddle, long term strangle, bull spreads or bear spreads, and they are useful in limiting the potential losses on any given trade.

Are Hedging Strategies Profitable?

An important thing to note about risk reduction with hedging is that it also implies a decrease in profits. Naturally, risk management is not free. This technique does not earn you money but instead minimizes your losses. If your initial investment makes money, you will lose on the other investment that you hedge with.

Hedging involves more than double the cost of opening regular trades, which can act against a trader if he is not careful about entering and exiting the market at the right time.

The main benefit of using a hedging strategy is that traders can minimize their losses and avoid massive drawdowns, especially during highly volatile market conditions. News, rate decisions, and other economic events can trigger significant movements in the market, which can result in massive losses. By hedging against such moves, traders can limit their losses and preserve their trading capital for the future.

Conclusion

Hedging in the Forex market is one of the most popular tools to limit exposure to different kinds of trading risks. With the right application, this method allows forex traders to reduce the risks with a minimum loss in profits. However, the only drawback of this method in Forex is at least a two-fold increase in the cost of opening a position.

Due to the complexity of hedging in forex, traders can never be fully assured that their hedge will counteract any possible losses. Even with a well-designed hedge, it's possible for both sides to generate a loss, even for experienced traders. Factors such as commissions and swaps should also be carefully considered. Therefore, traders should not engage in complex hedging strategies until they have a strong understanding of market swings and how to time trades to capitalize on price volatility.