Investors of all trends use hedging as a strategy to protect a position from adverse price movements. Normally, hedging involves the opening of a second position that is likely to have a negative correlation with the primary asset being held, meaning that if the price of the primary asset makes an adverse move, the second position will experience a complementary and opposite move that compensates for those losses.
In foreign exchange transactions, investors can use a second pair as hedging for an existing position that they are reluctant to close. Although hedging reduces risk at the expense of earnings, it can be a valuable tool to protect earnings and prevent losses in foreign exchange trading.
Understand the basics of Forex hedging
Currency hedging involves opening a position in one currency pair that counteracts possible movements in another currency pair. Assuming that the sizes of these positions are the same, and that price movements are inversely correlated, price changes in these positions can cancel each other while both are active.
While this eliminates potential benefits during this window, it also limits the risk of losses.
The simplest form of this is direct hedging, in which traders open a buy and sell position in the same currency pair to preserve the gains they have made or avoid further losses. Traders can adopt more complex hedging approaches that take advantage of known correlations between two currency pairs.
How a Forex Hedge works
The process of opening a foreign exchange hedge is simple. It begins with an existing open position, usually a long position, in which its initial operation anticipates a movement in a certain direction. A hedge is created by opening a position that goes against your expected movement of the currency pair, allowing you to maintain an open position in the original trade without incurring losses if the price movement goes against your expectations.
Often, this coverage is used to preserve the profits you have already made. The NOK / JPY chart below demonstrates a situation in which a trader might want to protect himself. If, for example, they opened a long position near the low point of that chart and capitalized the significant gains that developed in the following days, the trader can choose to open a short position to protect against any potential losses:
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Although the trader could also simply close their position and withdraw their profits, they may be interested in keeping that position open to see how chart patterns and technical indicators evolve over time.
In this case, hedging can be used to neutralize potential gains or losses as the trader maintains that position and collects more information. Even if the price plummets, they will be able to withdraw all the gains they generated from that initial rebound.
Creating complex forex hedges
Because complex hedges are not direct hedges, they require a little more business experience to execute them effectively. One approach is to open positions in two currency pairs whose price movements tend to correlate.
Traders can use a correlation matrix to identify currency pairs that have a strong negative correlation, meaning that when one pair goes up in price, the other goes down.
The combination USD / CHF and EUR / USD, for example, is a great option for hedging due to its strong negative correlation. By opening a USD / CHF buy position and a EUR / USD short, traders can hedge their USD positions to minimize their trading risk.
Trading currency options also creates hedging opportunities that can be effective when used in specific circumstances. An experienced operator is needed to identify these small windows of opportunity where complex hedges can help maximize profits and minimize risk.
When to consider coverage
Hedges are useful when you seek to maintain an open position in a match while compensating for some of your risk in that situation.
Short-term coverage can be a great way to protect earnings when you are unsure of certain factors that could cause volatile price movements. This uncertainty can range from the suspicion that an asset has been overbought to the concern that political or economic instability could cause certain currency pairs to fall in value, especially when it has opened a long position in those pairs.
In the USD / JPY chart shown below, a consolidation period is creating a potential breakout that could go either way. If you already have an open position in this currency pair and expect the price drop to break through the resistance line, you might consider hedging with another position, pointing to a rebound from the trend line towards previous highs:
If you open this hedge and the price breaks through the trend line, you can always close your second position and continue to reap the benefits of your successful short. But if you are wrong and the trend reverses course, you can close both positions and still withdraw your gains from the previous price change.
Traders often use hedges to protect against short-term volatility from economic press releases or market gaps during weekends. Traders should be aware that as hedging reduces commercial risk, it also reduces potential profits.
Due to the low returns created by hedging, this strategy works best for traders who work in the currency market full-time or have an account that is large enough to generate large monetary gains through limited percentage gains.
Coming out of a hedge
When you leave a direct or complex coverage and keep your starting position open, you must close only the second position. However, when you are closing both sides of a hedge, you will want to close these positions simultaneously, to avoid potential losses that may arise if there is a gap.
It is important to keep track of your hedged positions so that you can close the right positions, at the right time, to complete the execution of this strategy. With a view to an open position in the process you can derail your entire hedging strategy and potentially hit your trading account with heavy losses.
Always consider hedging risks
Although currency hedging is typically used to limit risk for traders, misplaced execution of this strategy can be disastrous for your trading account.
Because of the complexity of foreign exchange hedging, traders can never be completely sure that their hedging will offset any possible loss. Even with well-designed coverage, both parties may generate a loss, even for experienced operators. Factors such as commissions and swaps also need to be carefully considered.
Traders should not engage in complex hedging strategies until they have a solid understanding of market fluctuations and how time trades to capitalize on price volatility. Poor timing and complex pairing decisions could result in rapid losses in a short period of time.
Experienced traders can use their knowledge of market changes and factors affecting these price movements, as well as a strong familiarity with the currency correlation matrix, to protect their earnings and continue to create revenue through the use of timely currency hedges.