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    Hedging in Forex: How do Professionals Hedge?

    Minutes
    Updated Apr 27, 2023 06:20

    The world of forex trading can be volatile and unpredictable, with sudden market shifts and unexpected events creating uncertainty for even the most seasoned traders. 

    According to a Bank for International Settlements (BIS)  survey(2022), over 80% of the world's daily forex trading is speculative. This is where hedging comes in as a risk management strategy. 

    But what is hedging exactly, and what is the right way to do it in Forex? 

    In this article, we'll explore the ins and outs of hedging in Forex and offer some tips and strategies for doing it correctly.


    What is Forex hedging?

    Did you know that the word "hedge" comes from the Old English word "hecg," which means "fence"? 

    But what exactly is forex currency hedging, you ask? It's like wearing a sturdy cowboy hat to protect yourself from the harsh sun. 

    In other words, it's a way to minimize the risks of currency fluctuations by taking opposite positions in different markets. 

    According to BIS April's report (2022), the global forex market averages around $7.5 trillion in daily trading volume.

    With such a large market, currency fluctuations can occur quickly and unexpectedly, making hedging an important tool for traders.

    Let's explain this with an example of our imaginary friend Jim. 

    Let's say Jim holds a long position (buy) in EUR/USD, meaning he has bought euros and sold dollars with the expectation that the euro will appreciate against the dollar. However, Jim is concerned that some short-term volatility in the market could result in a loss. Jim could take a short position (sell) in EUR/USD at the same lot size as a long position to hedge his position. 

    By doing so, they have essentially locked in their profits or losses at the current exchange rate, irrespective of any short-term fluctuations in the market.

    So, Jim is a smart guy, and by applying the hedging technique, he can offset his losses. 


    When should you hedge?

    As the forex market is so dynamic, there are plenty of reasons to watch out when talking about risk exposure. 

    But there are generally 3 main situations where you will hedge while trading Forex:


    1. You are worried about news or events that could cause wild price swings

    One of the most common situations where traders use forex hedging is when they anticipate that market conditions will likely become volatile. This may occur when a significant news announcement, such as an interest rate decision or a major economic event. 

    In such situations, you may use hedging to protect your positions from sudden price swings that could wipe out your profits.

    For example, you are long on a EUR/USD currency pair but are concerned about the upcoming Fed policy meeting that it may cause the price to drop. 

    By opening a short position, you can hedge your position and limit potential losses.


    2. The market is getting worse, but you still expect prices to head in the right direction.

    Another situation where you may use forex hedging is when you are uncertain about the market's direction. 

    With all these fake gurus saying they know how the market will pan out, they don't know anything; nobody knows! 

    The uncertainty may occur during periods of market turbulence or when there is a lack of clarity about the future direction of a particular currency.

    For instance, when the pandemic hit, there was a lot of uncertainty in the market. When Russia invaded Ukraine recently, the markets were quite uncertain about the future course. 

    In such situations, you may use hedging to protect profits while waiting for the market to stabilize. 

    For example, let's say you are long on USD/CHF but are unsure whether the market will continue to move in your favor. 

    By opening a short position, you can protect your profits while you wait for the market to provide a clearer signal about its direction.


    3. When the order loss is too much, you can reduce the loss by hedging

    Forex hedging can also be used to minimize losses when trades go wrong. This is particularly useful when you have a stop-loss order, but the market moves against you before the stop-loss is hit. 

    In this situation, you may use hedging to limit losses and prevent the account balance from being wiped out.

    For example, you have a stop-loss order at 109.47 on a USD/JPY long position. However, the market suddenly drops, hitting the 109.47 level, and you find yourself with a significant loss. 

    By opening a short position on the same currency pair, you can limit your losses and prevent further damage to your account balance.


    Why should you use forex hedging strategies?


    • ● We've all been there, watching in horror as our hard-earned profits disappear into thin air. By hedging your positions, you can limit potential losses and protect your profits from sudden market movements.

    • ● Another advantage of forex hedging is that it gives you more flexibility in your trading strategies. By opening both long and short positions simultaneously, you can take advantage of both rising and falling markets and adjust your strategy as market conditions change. 

    • ● Using forex hedging, you can risk managing to diversify your portfolio effectively and spread risk across different currency pairs. This can reduce the impact of any losses on a single position and provide more stable returns.


    The risks in hedging Forex

    Forex hedging provides a safety net; however, like any safety net, risks are involved. 

    Here are some risks you should be aware of:

    • Let's face it; there are no guarantees in the forex market. Even the best hedging strategies can't protect you from every risk. In fact, according to a study, some hedging strategies can even increase your risk of losses if not executed properly. 

    • Another risk of forex hedging is the additional costs involved. You may need to pay extra fees, commissions, or even more capital when you hedge your positions. 

    • Finally, one of the biggest risks of forex hedging is that it can overcomplicate things. When using multiple hedging strategies and instruments, keeping track of your positions and managing your risk can be difficult. This can lead to confusion, mistakes, and potentially costly losses.


    3 Best Forex Hedging Strategies

    So, you want to hedge your forex trades? Well, there are a lot of different strategies out there. Here, we'll mention the best three forex hedging strategies you can apply.


    Hedging with opposite directions

    One of the most popular hedging strategies is to take the opposite position. In this way, you help mitigate the risks involved. 

    For example, let's say you've gone long on the EUR/USD currency pair, but you're starting to get nervous about potential downside risks. 

    One way to hedge your position would be to take a short position on the same currency pair, essentially betting against yourself. 

    If the market does move against your long position, your short position will offset some of your losses. 

    Now, we know what you're thinking. 

    Are you betting against yourself? Isn't that like playing both sides of a sports game and hoping for a tie? Well, in a way, yes. But in the forex world, sometimes playing both sides can be a smart way to manage your risk.


    Example

    Forex hedging in the opposite direction

    In the chart above, you can see we entered the short trade, but after some time, the price started moving in the opposite direction. So, we entered the long trade to limit our risk exposure. 

    You should know that if the market moves in your favor, your hedge position will also start losing money, canceling some of your gains. 

    In our case, the market went upwards, and our initial short position would have resulted in losses, scratching our gains. So, you must be careful when entering the hedged position and exiting the initial position.


    Hedging With Correlating Currency Pairs 

    When it comes to hedging Forex, traders use hedging with correlating currency pairs. This strategy involves taking positions in two currency pairs with a high positive or negative correlation to mitigate risk. 

    Let's break it down.


    Example1: currency pairs have a positive correlation

    Currency pairs with a positive correlation tend to move in the same direction.

    For example, the EUR/USD and GBP/USD pairs positively correlate because they both involve the US dollar as the quote currency. 

    If the USD strengthens, both pairs will likely decline in value. In this scenario, you could hedge your long position in the EUR/USD by taking a short position in the GBP/USD. 

    If the USD strengthens, the gains from the short position in the GBP/USD will offset some of the losses from the long position in the EUR/USD.


    Example2: currency pairs have a negative correlation

    Currency pairs that have a negative correlation tend to move in opposite directions. For example, the EUR/USD and USD/CHF pairs negatively correlate. 

    If the USD strengthens, the EUR/USD will likely decline in value, while the USD/CHF will likely rise. In this scenario, you could hedge your long position in the USD/CHF by taking a short position in the EUR/USD.

    The charts above show that while the USD/CHF increased between May 21 and November 25, the EUR/USD declined. If you were short on USD/CHF, you would have limited your risks by taking a short position on EUR/USD.

    Hedging with Forex CFDs

    Forex CFDs (Contracts for Difference) are popular choices among many traders. Hedging with forex CFDs involves opening two trades on the same currency pair, one long and one short. 

    If the market moves in the opposite direction to what you anticipated, the loss from one trade can be offset by the gain in the other trade.

    Example

    Let's say that you have a long position on the GBP/USD pair, but you are concerned that the upcoming US Non-Farm Payroll report might cause a sudden drop in the value of the pair. 

    You could also open a short position on the same currency pair to hedge your position. If the market does indeed drop, your long position will incur losses, but gains in your short position will balance these losses.


    Finding the right hedging strategy

    All the abovementioned strategies can help you mitigate the risks of forex trading. 

    However, finding the right forex hedging strategy can be like finding a needle in the haystack, as it requires careful consideration of various factors.

    Here, we'll mention factors you must consider before finding the right hedging strategy.


    Effectiveness

    The effectiveness of a forex hedging strategy depends on the ability of the strategy to offset potential losses. 

    A hedging strategy should be able to protect against adverse price movements while allowing you to benefit from favorable price movements.

    The effectiveness of a hedging strategy can be measured by comparing the actual returns of your forex account with the expected returns, taking into account the impact of the hedge. 

    For example, your absolute drawdown is 10% in a year. However, after hedging, the drawdown is reduced to 8%. It means the effectiveness of hedging is:

    (Previous drawdown - recent drawdown) / previous drawdown *100,

    which is (10-8)/10 *100 = 20%


    Total cost 

    Another important factor to consider when evaluating a forex hedging strategy is the cost of implementing the hedge. 

    The cost of the hedge can include transaction fees, commissions, and other charges that your broker may charge. It would help if you weighed the cost of the hedge against the potential profits to determine whether the hedge is worth implementing. 

    It would be best if you also considered the impact of the hedge on the overall returns, as a high-cost hedge may not reap any fruits for you. 


    Recognizing the importance of volatility

    Volatility is the degree of fluctuation in a currency pair's price over time. It is an important aspect of the forex market that affects the profitability and risk of trading positions. 

    The higher the volatility, the greater the uncertainty and risk involved in trading. Recognizing volatility is key for forex hedging strategies because it allows you to anticipate and manage risk effectively. 

    By understanding the market conditions and the potential impact of volatility, you can adjust your positions and strategies to minimize losses.


    Key takeaways

    So, there you have it! Now you know what forex hedging is, the different types of strategies, which factors to consider when applying the hedging strategies, and the pros and cons of forex hedging. 


    Here are some key takeaways from the guide:


    • ● The hedging strategy can help you manage risk in the forex market by reducing potential losses.

    • ● There are different types of hedging strategies. Each type has pros and cons; you must understand the risks involved.

    • ● Over-hedging can lead to increased costs and can limit potential profits. So, you should only hedge the amount necessary to protect your position and not more than that.



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    * The content presented above, whether from a third party or not, is considered as general advice only.  This article should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments.

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