HEDGING STRATEGIES IN FOREX TRADING
Hedging is a forex strategy that is used to protect one’s Forex trades from unfavorable positions. It is a form of protection put in place by a trader when an event occurs triggering volatility in the Forex markets. There are two main types of hedging strategies for forex traders. They include the opposite position of the currency pair. And the second strategy is the purchase of Forex options.
HOW TO USE HEDGING STRATEGIES
The hedging strategy is similar to a stop-loss order. They both do similar work, which is to limit losses. However, the good thing about hedging is that you can generate profits from the hedge trade if it is selected with caution.
Many traders mistake hedging strategy as a means of placing an equal trade to contradict an already open trade. In other words, if you buy a standard lot of EUR/USD, you also sell 1 lot of EUR/USD to neutralize the first trade. However, hedging is different; this is not how it works.
A forex hedging strategy is used to stop the loss or profit during a trade reversal. This strategy requires opening a buy and sell trade of the same forex pair simultaneously. In a case where you go short and the market is bullish, you’ll buy to hold temporarily. The position is held until the market reverses back.
Traders often make the mistake of leaving the trade open for weeks and months. This happens when they think they are fully tested, so nothing to worry about. However, that is not always the case. Other factors could gravely affect the performance of the trade. For instance, the carry cost. If caution and discipline are not applied, this could lead to a bigger loss.
Most Traders do not like the idea of hedging their trades. But no matter how you look at it, forex hedging has its benefits.
ADVANTAGES OF HEDGING STRATEGIES IN FOREX TRADING
- The main purpose of hedging is to reduce risk in a trade. Hedging strategy allows traders to withstand the downside of the market or economic decline. A perfectly executed hedging strategy offers safety against modifications in central bank interest rate, inflation, variations in the price of commodities, etc.
- Traders can use derivatives like Futures and Options in short trade strategies. This is to lessen the risk of long trades.
- Some traders use hedging tools to lock at their trades. Over time the benefits of hedging turn to long-term goals.
- The hedging strategy saves time. They do not give traders with extended horizons the ability to modify their portfolios with the everyday trade market volatility
DISADVANTAGES OF HEDGING FOREX
Forex hedging comes with its disadvantages also. Although hedging helps in minimizing risk, it is also a risky strategy. Even with its advantages, it still has many disadvantages.
Listed below are some disadvantages that come with Forex hedging.
- Traders who use hedging must be experienced. The hedging strategy requires proper implementation; it cannot be implemented by just any trader. Amateur traders will find the hedging strategy difficult to use. If this strategy isn’t put in place properly, it will lead to more losses. Hedging aims to protect funds, but if not implemented properly it will lead to loss of funds. Thus, a new trader is advised to practice the hedging strategy using a demo account. With a demo account, the trader can fully master the strategy without the fear of losing funds. They are to use the strategy in a live account only when they are confident.
- With hedging the risk and reward numbers are proportional. That is when the strategy reduces your trade risk, it also reduces your potential profit. A good hedging strategy protects your funds from a short-term trade loss. The strategy should not reduce your long-term trade potential profit.
- A typical Forex hedge does not come free. A forex hedging technique has a price cost that could overshadow a trader’s gain. For example, the use of Forex Options for a hedging strategy.
- Hedging strategy favors the swing traders and positions, traders, more. Traders with shorter time horizons will find the strategy difficult to implement. For example, day traders.
- Hedging gives off little profits when the exchange rate of the forex pair swings within the trading range.
- It is important to note that hedging takes up more equity. Before you can place a heading strategy you must have enough capital to cover a direct hedge. For some traders who prefer to use the Forex options, your capital must be large enough to cover the premium cost. For traders with lower capitals, it is advisable to use tighter stop loss on their trades. This way they can still curtail losses without using much capital.
TYPES OF HEDGING STRATEGY
There are different types of Hedging strategies in Forex trading. But we will group them into two.
This strategy entails a forex trader creating a hedge to completely protect an open trade from an unfavorable move. It’s done by opening both a long and short trade at the same time on the same Forex pair. This type of hedge is called a perfect hedge because it removes any involved risk. This type of is a risk-free trade, it takes away any risk and also the potential profit. The trader never losses or gain in this type of trade.
However, it sounds odd to sell a currency in your long trade. This is because the two trades contradict one another. However, many traders open such trades all the time. This type of hedge often surfaces when a trader opens a long and short-term position. When an event that can trigger market volatility occurs, they open a contrary trade instead of liquidating it.
However, in the United States, Forex traders are not allowed to open such contradictory trades. The trading firms are expected to close the two positions. The firms deduce the contradictory position as a close order. Nevertheless, the outcome of the closed trade and a hedged trade is virtually the same.
This is the act of creating a hedge to partially protect an already open position from an unfavorable market move. A Forex trader carries out this hedging by using Forex options. Unlike the first strategy, this strategy is known as the “imperfect hedge”. This is because the strategy only removes part of the risk inclined with the trade.
To develop this strategy, a trader with an open long Forex pair trade can purchase put option contracts to minimize the downside risk. While a trader with a short open trade can purchase call option contracts. This is to minimize the risks coming from the upside of the trade.
There are two types of Imperfect hedges. Let’s take a look at them.
- The Imperfect Downside Risk Hedges
- The Imperfect Upside Risk Hedges.
IMPERFECT DOWNSIDE RISK HEDGES
This strategy requires the Put Options. The Put Options give the buyer the ability to dispose of a Forex pair at a particular price. This can be done on a stated date, or before the date. This price is called the strike price, while the date is an Expiration date. The trade is sold to an options seller in exchange for receiving the compensation of an upfront premium.
A trader goes long with EUR/USD at 1.3575. The main aim is to generate profits from the trade as the price moves higher. But with how volatile the market can be, the trader is also concerned about losing on the trade. Probably as a result of an important economic data release. The trader will then hedge the risk by buying a put option contract with a specified price below the current buy price. Like 1.3550, with the expiration date stated after the economic data release.
However, if the announcement does not affect the trade negatively, the trader can leave the trade open. In this case, the trader makes more profits as the price increases.
However, in a case where the announcement negatively affects the open trade, the put options will limit part of the loss. When the put options trade is opened, the risk becomes equivalent to the difference between the price the options contract was purchased for, and the limit price of the options, including the price paid for the options contract.
1.3575-1.3550 =0.0025. Which is equivalent to 25 pips. So in this case, the trader only lost 25 pips. Even if the trade falls lower than the strike price, the highest loss incurred will be 25pips.
IMPERFECT UPSIDE RISK HEDGES
Call options contracts allow traders to buy a Forex pair at a strike price. The currency pair can also be bought before the expiration date. This gives a buyer the right to exchange the trade for the fee of an upside premium.
A trader goes short with GBP/USD at 1.4335, speculating the pair to go lower. However, the trader is worried the pair will have an uptrend if the vote proves to be bullish. The trader buys a call option contract at the strike price to hedge a portion of the risk. The strike price is placed above the present exchange rate, like 1.4.375. The expiration date is set at a later date after the anticipated vote.
If the vote occurs, and the price of GBP/USD does not go bullish, the trader keeps the short trade open. That means the trader gets more profits from the trade as long as it’s bearish.
However, in a case where the GBP/USD goes bullish, the call options come into play. The call option limits the risk to the difference between the price of the currency pair when it was bought and the strike value of the option.
In this case of GBP/USD, it is 50 pips.
1.4375-1.4355= 0.0050. Including the price paid for the options.
In a case where the GBP/USD moves higher than the stipulated price, the strike price comes into effect. The risk attained will not be more than 50 pips.
GOLD HEDGING STRATEGIES
As a trader, if you want to secure your trades against increased inflation, the perfect hedge is Gold. The exchange rates of Gold tend to increase when there is increased inflation. However, Gold acts as a hedge against the reduced price of the US dollar. That is, there is an opposite correlation between the USD and the gold exchange rate.
Simply put, when the price of gold increases, the price of the US dollar reduces and vice-versa.
According to history, Gold has always been the equivalent of money. This is the reason why it is seen as a good hedge against weaker USD or increased inflation.
It is important to note that hedging doesn’t always work. But this trading strategy is reasonable and works for most traders.
OIL HEDGING STRATEGIES
The significance of the oil price has proved to expose many currencies. A good example is the Canadian dollar. Normally, the oil price and the Canadian dollar price have a favorable correlation.
When the price of Oil appreciates, the USD/CAD price reduces.
In a case like this, the exposure of the USD/CAD trade is hedged by the oil hedging strategy. For example, when you go long on USD/CAD and go short on an Oil hedging position.
Most traders use hedging positions not because it is a good strategy, but mostly because of psychological reasons. The use of hedging strategies in forex trading gives a trader peace of mind concerning the trades involved. It helps the trader think they are right about their trade and will take the hedge off if the trade is favorable.
It is important to note that hedging strategies are not free. Irrespective of the type of hedging being implemented, a price has to be paid. Hedging is equivalent to buying insurance to curb losses.
Finally, a good way to reduce the risk on your trade is through hedging. It helps you protect your losses and also helps make a good profit.