How to use a Forex hedging strategy?

To combat such events and protect their funds, forex traders can implement hedging strategies that mitigate the downside risk to an extent.

Hedging refers to the use of financial instruments to safeguard already existing positions from sudden losses. For example, hedging a short position could involve going long on another similar instrument – if one underperforms, the other can help mitigate losses by overperforming.

Such strategies have been a mainstay in the trading/investing communities all over the world and are essential tools for traders to protect their wealth from sudden uncertainties on the market.

Core features of Forex hedging strategies

• The purpose of forex hedging strategy is to protect existing assets
• Traders typically use two distinct hedging strategies – trading against an existing position or using forex options
• Trading against an existing open position is capital-intensive and requires similar amounts of pledged capital as the initial position, however, hedged positions are closed as soon as danger goes away
• Using options is a more cost-effective way, but may involve losing an entire hedging position
• Hedging using options is time bound but does not involve an obligation to deliver the underlying asset
• Traders can choose what portion of an initial position to hedge against

How does forex hedging work in trading?

Hedging strategy in FX is built for protecting long term positions from short term disruption. For instance, when traders have huge long positions and a news announcement is approaching that can negatively impact the position short term, traders place an opposite trading orders just to eliminate risks that are coming from that announcement. Once the danger is gone, traders close hedging orders. Hedging is a highly complex process. It requires managing multiple trades and timing entries and exits with great accuracy. And therefore, hedging might not be for beginner traders.

The primary approach to hedging used by traders is forex options. When an existing position becomes riskier than acceptable for a trader, they can buy options that will profit from the trade going in an opposite direction. For example, a trader that is long on GBP/USD may buy put options to mitigate the downside if the pair starts to lose value.

Hedging using options is also known as ‘imperfect hedging’, as it can only cover a part of an initial position. We will discuss the difference between ‘perfect’ and ‘imperfect’ hedging below.

The best forex hedging strategy is not there to give you profitable trades. Top hedging strategies are developed to increase safety of longer trading positions from short time fluctuations.

‘Perfect’ hedging

A perfect hedge refers to a hedging strategy that completely eliminates both the downside and upside potential of a position. This happens when a trader wants to fully hedge against a long or short position by opening an exactly similar, opposite position. While this may seem counter-intuitive, such hedging occurs quite often when traders are expecting a significant increase in volatility caused by a major event/news release. Instead of closing the trade, traders will simply ‘neutralize’ its downside to wait out the major news event. However, such hedging practices are not available for US traders, and opening long and short positions of equal sizes on the same instrument will close the position. The drawbacks of perfect hedging are that it completely foregoes any profitability that otherwise could have been achieved by an open position.

‘Imperfect’ hedging

Imperfect hedging refers to the partial hedging of an open position by using forex options. Instead of alternating between long and short positions, traders can simply buy options that will profit from the opposite price direction. Short positions can be hedged by call options, while long positions – with put options. This hedging method covers a portion of the possible losses from an open position and is used to offset sudden bursts of volatility on the market. It can also be used to reverse positions when they are underperforming considerably.

Hedging limitations

While hedging is an important part of a well-balanced trading strategy, it does come with some limitations. Hedging is usually required when a trader has doubts about the possible performance of their positions. The market is constantly moving and forex markets, in general, are characterized by a higher degree of volatility than other asset classes.

Imperfect hedging does not fully offset the risks associated with maintaining open positions, while perfect hedging completely neutralizes any upside and downside positions a trade may have. Making neutral trades is never on the agenda of successful traders, and hedging strategies are simply there to act as a safety lever to offset major losses. Perfect hedging is also not technically viable for US traders, and such positions are automatically closed on the market.

Pros and cons of Forex hedging

Hedging in forex is not a perfect solution from downside risk, and weighing up its pros and cons is important for traders to understand which method of hedging to use in what scenario.

Pros

• Hedging allows traders to mitigate losses during hard market conditions
• Forex options are a great way to hedge against volatility in the short term
• Hedging can save time and require less active monitoring from traders
• Successful hedging protects capital from increased volatility, inflation, rising prices, etc.
• Using options for hedging can open up new profitable strategies for traders

Cons

• Hedging involves additional costs
• Reducing risks means reducing profit potential
• Hedging is less accessible for short term traders who need to make quick decisions
• Using options for hedging means more capital requirements for traders
• Hedging offers little to no benefit when the market stabilizes
• Successful hedging requires knowledge and experience that some traders may not have
• Hedging is a complex process, and it might be too difficult for novice traders

Forex hedging strategy example

To understand the practical side of forex hedging, let’s look at examples of hedging strategies to see how they work.

Correlation

A correlation hedging strategy involves trading pairs with the same base currency against quote currencies that perform similarly. Such strategies are especially useful when using major pairs and currencies that are pegged to the US dollar. For example, if a trader wanted to hedge against a long position in GBP/USD, they could short or buy put options on the GBP/SAR pair. This works because the Saudi riyal is pegged to the dollar at a fixed rate, which allows traders to use the currency interchangeably in hedging strategies.

This is a simplistic example of correlation hedging. More advanced traders use correlation matrices to determine the degree of correlation between two currencies to use them effectively in hedging.

Imperfect upside hedge

Let’s assume a trader is short EUR/USD at 0.9900 and expects it to move lower. However, there is a risk of the pair going higher if the ECB releases a bullish statement. The trader can hedge using a call option with a strike price just above the short price and an expiry date just after the scheduled press release, at 0.9950.

If the pair does not move higher after the statement is released, the trader can hold their position unchanged and profit from the downside. The cost for this hedge is equal to the premium paid for the call option, which would be fully lost if the pair continued trending downwards.

If the pair actually moves up after the statement, the loss from the bullish run would be limited by the premium paid for the call option.

Imperfect downside hedge

For an opposite example, let’s assume a trader is long GBP/USD at 1.1150. The trader expects the pound to continue climbing against the dollar, but is also anticipating an important meeting scheduled by the Bank of England. The news from that meeting is likely to create bearish sentiment on the market in the short term. The trader can hedge against this by buying put options for the pair with a strike price of 1.1100 that expire just after the official meeting minutes are released to the public.

If the pair does not dip after the announcement, the trader can hold onto their position, which performs as initially intended. The cost of the hedge is equal to the premium paid for put options, which would expire worthless if the pair continued trending upwards.

If the pair starts to dip after the meeting, the loss would be limited to the difference between strike and long prices, which is 1.1150–1.1100 = 50 pips, plus the premium paid for the put options.

FAQs on forex hedging

Is forex hedging strategy allowed?

The hedging strategy for Forex that requires opening two opposite direction trades in the same currency is not allowed in some countries. Such practice is banned in the USA, however, you can use correlated currency pairs to hedge your risks. Forex hedging strategies can be used by experienced traders to protect against increased volatility. They can do so using long/short positions and options.

Is forex hedging strategy risky?

The purpose of hedging is to reduce risk and protect existing positions from sudden losses. However, successful hedging requires practice and inexperienced traders might not be able to fully take advantage of the benefits offered by hedging. Hedging is complex, and the benefits offered by hedging might not be worth the energy and time it takes for novice traders.

What are the costs of a hedging strategy?

The cost of hedging using options is equal to the difference between the initial and strike prices, plus the premium paid for options contracts. When hedging using correlated or the same currency pairs, costs of hedging include spreads and trading fees that are required to open trading positions.