forex hedging

As a financial trader, knowing how to guard against sharp price movements should come hand in hand with knowing how to profit from them. Although many traders are familiar with when to buy and sell assets, knowing how to mitigate and prevent losses is just as important, and risk management is vital for traders who want to get better at their craft. This is where hedging comes in.  

What is hedging?

Hedging is an investment made to reduce or prevent losses that may incur from unexpected market price fluctuations. In a way, hedging works like insurance, limiting risks against sharp price movements in an unfavourable direction. Frequently, but not always, a trader hedges an existing position by opening a second one, in which they bet on the reverse scenario. This is so that any losses incurred on the first position can be mitigated by profit on the second one. Hedges can be used by businesses, investors, retail traders, and other market participants. They are generally used not to make a profit but to limit risk and guard against losses. Therefore, they are usually employed on a short-term basis when a trader is worried about temporary but significant shifts in the market against their favour. In these cases, the trader may not want to close their original position as they believe the hit will pass soon. However, they do not want to take it directly and lose a lot of money either. So, for the time being, they insure their original position using a hedge until the storm passes.  

How does forex hedging work?

In forex, hedging is a way for traders to protect themselves from exchange rate fluctuations in the forex market. As the largest and most liquid market in the world, dramatic currency price movements can happen instantly with the announcement of political and national news. Forex hedging, or currency hedging, is a way for forex traders to guard against these sudden movements. There are three main forex hedging strategies. They are direct hedging, cross hedging, and hedging using currency options. All three methods are commonly used as a short-term solution, and whichever one a trader uses depends on their personal preferences and knowledge of the hedging strategies themselves.

Direct hedging

Direct hedging is opening an opposing position using the same currency pair as the one currently being traded. Currencies are always traded in pairs, meaning that a forex trader is always buying one currency and selling another at the same time. A direct hedge is thus made possible by simply reversing the existing position. A forex trader who is going long AUD/USD can create a direct hedge by opening a new position to go short AUD/USD with the same lot size. In doing this, however much AUD fluctuates, the trader will have a net balance of zero, cancelling out any losses that may incur on one position with profits on the other.  

Example
A forex trader has a position open going long AUD/USD. They predict that it is likely AUD will depreciate soon, but they do not want to close the position as they believe it will only be a temporary depreciation. They decide to hedge the currency risk of AUD depreciating. To do this, they short an equal amount of AUD/USD at the same time. This way, when the price of AUD does end up depreciating relative to USD, the forex trader would still make a profit, and this profit will be able to make up for the money lost from his original long position on AUD/USD. Later, when AUD begins to appreciate relative to USD again, the forex hedge is no longer needed as the risk is no longer present, and the trader closes their second, short position.
 

Cross hedging

Correlated hedging involves taking two positions on two different currency pairs. The forex trader can choose any currency pairs as long as they are positively correlated. Doing so, a cross hedge is immediately created.

Example
A forex trader who goes long GBP/AUD buys British pounds and sells Australian dollars. As a big football tournament is set to take place in Sydney soon, there are predictions that AUD will appreciate relative to GBP as tourism surges in Australia. This means that the trader will lose money if they keep their long position open. However, they do not want to close it just yet, as they know this is a temporary rise that will pass. To offset this loss, they create a cross hedge by opening a new, long position on AUD/USD. When AUD does indeed appreciate relative to GBP and other currencies it is paired with, the trader sustains a loss on their first position selling AUD but makes a profit with their second position buying it back.
In cross hedging, depending on the position sizes and exchange rates of the positively correlated currency pairs, the forex trader may even be able to make money in the case of one position generating a profit greater than the loss sustained from the opposing position. However, forex market fluctuations are volatile, and a trader is equally likely to lose money from hedging.

Hedging with currency options

A currency option is also known as a forex option, and it involves hedging with an options contract. An options contract gives the holder the right, but not the legal obligation, to go long or short on a currency pair at a given price before or on a set expiry date. This contract is obtained when the buyer of the option pays the seller a premium. A forex trader expecting a decline in the value of a currency he is buying can state a price in the options contract. This is the price at which he will be able to sell his lot and close his position, even if the currency value does depreciate. The contract will also specify an expiry date.  

Example
A forex trader who is going long on AUD/USD opens his position at $0.74. However, soon after, an unexpected event happens, and it seems likely that AUD is about to depreciate sharply relative to USD. To guard against potential losses, the trader decides to hedge this risk by purchasing a put option at $0.73 with a one-month expiry date. If AUD does depreciate sharply within the month, the trader can exercise the option and close their position at $0.73, limiting their losses considerably. If AUD appreciates instead, the trader can take no action and let his options contract expire.
Hedging with currency options is common among forex traders for two reasons. Firstly, the maximum loss that can incur with this method is the premium paid to the seller. Secondly, forex traders who do not like to open several positions simultaneously will not need to.  

Key takeaways

Hedging in forex is a helpful method for traders to guard against or minimise potential losses from sharp and unfavourable price movements. Although the primary motivation for traders who hedge is not to profit, it is a possibility. There are three main forex hedging strategies: direct hedging, cross hedging, and hedging with a currency option. As this is considered a more advanced strategy in forex trading, traders should have sufficient market experience and knowledge of forex trading instruments to minimise financial risk. Open a free demo account to familiarise yourself with various hedging strategies before placing live trades.

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