There’s danger involved with trading forex. Nothing is sure, even if you research the market, perform your own technical analysis, and enter the market when you think it is best. Forex hedging, on the other hand, allows you to hedge your trades against a particular level of risk. Here’s our beginner’s introduction to forex hedging methods to help you understand what this entails.
What is hedging?
Holding two positions at once in an attempt to lower your losses is known as hedging. The roles you play ought to be somewhat dissimilar from one another. For example, as a hedge, you can open a long position (i.e., you believe the value will increase) if you are short on a currency pair (i.e., you believe its value will decline).
Therefore, in this case, you could profit if either the long or the short position is successful. In order to mitigate any possible losses, you have so successfully hedged one trade against another.
It’s crucial to clarify right away that hedging won’t shield you from all losses. This implies that neither direction will allow you to fully protect your investment. What you can do, though, is guard against specific results.
As such, hedging in forex should not be viewed as a means of ensuring a profit or eliminating all risk. It cannot make forex trading completely risk-free, but it can in some cases lessen certain possible hazards. All forms of trading have some inherent risk. Therefore, using hedging or any other trading method, it cannot be eliminated.
In forex, how do you hedge?
In the forex market, hedging is primarily employed as a risk-reduction strategy to lessen the impact of transient market fluctuations. When trading forex, there are methods for hedging. Nonetheless, there are two general approaches to dissect this tactic
Perfect hedge
Having both a short and long position in the same currency pair is known as a perfect hedge. Let’s assume that you own a long position in the USD/EUR pair. This indicates that you are prepared to hold this currency pair for a long time because you think its value will rise.
Let’s imagine, though, that some political developments in the United States have you wondering if there might be some volatility in the near or medium run. Rather than ending your long position, you establish a short position because you believe that this volatility will ultimately lead to a decline in the value of USD/EUR. This indicates that you are purchasing and selling the same currency pair at the same time.
As such, whether the USD/EUR exchange rate rises or falls, you are in the right position. Because of this, it’s an ideal hedge because you can’t lose.
But it doesn’t mean that this is a risk-free approach because you’re also taking away your opportunity to earn by removing the possibility that you’ll lose money. This is due to the fact that any profits you gain from one position are offset by any losses from the other. It is not a risk-free technique as a result.
A perfect hedge is only useful for a limited amount of time for forex traders who wish to hold onto a long position while safeguarding themselves against short-term volatility. Traders will exit their short positions once it looks as though the market is shifting into a favorable position.
Inadequate hedge
In forex trading, using put options contracts to counter an existing position is an imperfect hedge. You might not always be able to do this with your trading platform, but Saxo Bank offers FX options.
Derivatives based on underlying currency pairings are known as forex options. Vanilla and SPOT (single payment option trading) are the two primary categories of forex options. These are options that grant investors the right, as specified by the contract, to purchase (call) or sell (put) a certain currency at a predetermined price on an execution date.
Options contracts come with a crucial disclaimer: while they grant investors the ability to purchase or sell, there is no requirement to do so. It is “optional” for you to fulfill the contract or not. An investor can specify how much of a specific currency pair they want to purchase or sell, the price they want to pay, and the date they want to fill their order by taking out a vanilla option.
You have placed this order using your account. After that, the buyer/seller returns with a premium quote. The options contract begins if the investor agrees. They do not truly own the underlying asset; instead, they maintain a buy/sell position on a currency pair.
Example of forex options
Assume for the moment that you are long JPY/USD. This indicates that you are the owner of the underlying asset and that you are holding it in anticipation of a rise in value. By purchasing forex options, you wish to hedge against a specific level of short-term loss. Consequently, you buy a put option on the JPY/USD pair. In the event that the JPY/USD exchange rate declines, your put option will profit. You will profit from your long position but lose money on the put option if it rises.
A synopsis of unsatisfactory hedging and forex options
Given that this is a complex topic, the following is a synopsis of using forex options for imperfect hedging:
- Virtual contracts known as forex options grant you the right to purchase or sell a pair of currencies at a later time. You are buying the right to make the move you want in the future, but you are not required to fulfill this contract.
- Contracts for options may be purchased (call option) or sold (put option). Purchasing entails taking a lengthy position. Selling is equivalent to establishing a short position.
- Since options contracts are derivatives, you cannot buy the underlying asset—in this example, currency pairs—into them. Rather, you are paying for the privilege of transacting (buying or selling) a pair of currencies.
- One can have another position and have an options contract at the same time.
- Because you won’t be able to completely offset your losses on either side, these hedges are referred to as imperfect. Nevertheless, this method is used by forex traders since, based on the investments you make, it allows you to limit your losses while still making a profit.
Strategies for Hedging in Forex
Thus, there are two primary forex hedging strategies: flawless and flawed. In brief, these two approaches are:
Flawless Hedging
This approach, also referred to as direct hedging, necessitates opening both long and short bets on the same currency pair. Because your losses will offset your profits, there is no net profit. On the other hand, as a short-term tactic, it can serve as a hedge against volatile long positions.
*It’s not always feasible to hedge perfectly, so be sure before initiating a trade.
Inadequate hedge
You have to maintain a position on a currency pair in order to use this technique. After that, you purchase an options contract that goes the other way. The benefit of this technique is that it gives you room to profit, even if it will be smaller than it would be with a single position. It won’t wipe out all of your gains.
Taking positions on several currency pairings is the last forex hedging tactic you can consider. Holding two closely related currency pairings is the goal here. In the case of EUR/USD, for instance, you may be long and short GBP/USD.
You are taking two opposite positions when you use this forex hedging method. Both of these positions contain USD even though they aren’t on the same currency pair. Thus, in this case, you are reducing the risk associated with retaining USD. Thus, you may have two positions on the USD using these two currency pairs if you believe something that happens in the US will lower the value of the USD.
The dangers of hedging in currency
Not all risk can be eliminated by hedging, and in some cases, your net profit will be zero. This implies that using forex hedging to ensure a profit is not possible. You can have to pay trading fees even in cases when you make every effort to reduce your risk and end up with a zero net return; in that scenario, a perfect hedge would actually cause you to lose money.
Additionally, forex hedging methods can be challenging to comprehend and put into practice, especially for inexperienced traders. When you start trading FX options, this drawback intensifies. Lastly, there is a strong correlation between risk and profits. You will therefore lose the same amount of money on both positions if you win on one.
Because of this, hedging is a helpful technique in the near term but less so in the long run. A profitable single position may yield higher returns on investment over the long term than a profitable hedged position. All of these are crucial things to think about.
In periods of brief volatility, you can safeguard your long positions by using effective forex hedging techniques. Forex hedging, however, shouldn’t be viewed as a simple means of generating gains that are assured and of completely removing all risk over the long haul.
Conclusion
By balancing possible losses, forex hedging reduces risk, particularly in times of short-term market volatility. It lowers exposure, but it doesn’t guarantee earnings or completely remove all dangers. Hedging should be used strategically by traders, who should weigh possible profits against the expense and difficulty of the tactic. While imperfect hedges permit some fluctuation based on market conditions, perfect hedges balance out earnings and losses.
FAQ’s
What is hedging in forex?
Keeping two opposite positions in forex hedging helps to minimize possible losses from market swings.
Is hedging free from risk?
No, hedging can reduce some risks, but it can’t guarantee profits or completely eliminate losses.
A perfect hedge is what?
To totally eliminate risk, a perfect hedge entails having both long and short positions on the same currency pair.
An incomplete hedge is what?
An imperfect hedge lowers risk while allowing for some profit or loss by using forex options or related currency pairings.
Which situations call for hedging?
When keeping long holdings under unpredictable market conditions, hedging is very helpful in controlling short-term volatility.