The forex market has been especially volatile in recent decades. Foreign exchange risk is the term used to refer to the potential losses from currency fluctuations in an international financial transaction. It refers to the chance that the value of an investment would decline due to changes in the relative values of the currencies involved. This may be a kind of jurisdiction risk for investors and businessmen involved in international trade. Hedging your forex positions is a popular strategy to reduce unwanted exposure to risk from forex price volatility.
What is hedging?
Hedging is the process of buying or selling financial instruments in order to offset or balance your current positions and lower your exposure to risk. FX hedging, in particular, is the act of strategically opening additional positions to protect against adverse price movement.
Currency hedging is a risk management strategy used by short- to medium-term traders and investors to protect themselves from unexpected changes in interest rates, exchange rates, and other aspects of the forex market. This is because the FX market can shift in response to political or economic events in any country. It is not commonly used as part of a short-term strategy because such price fluctuations have little impact on buy-and-hold investors.
How does it work?
The procedure for opening an FX hedge is straightforward. It all starts with an open position—usually a long position—in which your initial transaction is anticipating a move in one direction or another. A hedge is created by taking a position that is the inverse of your projected currency pair movement, allowing you to keep your initial position open while avoiding losses if the price movement goes against your expectations.
Assume you were long on GBPJPY when you opened your position at 160.50 yen. You predict that the pair will fall sharply today, so you choose to hedge your risk by buying a daily put option on GBPJPY with a strike price of 156.50 yen.
Your option will be profitable if the price of the pair falls below 156.50 yen by the time of expiration. You might utilize the profit to compensate for any losses in your long GBPJPY transaction.
If, instead, the pair had appreciated in value, you could have let your position expire worthless and just paid the premium. Your long trading profit could cover part or all of this expense.
Hedging strategy for forex correlations
There are numerous correlations between FX pairs. Pairs trading is an advance forex hedging method that entails taking one long and one short position in two different currency pairs. This second currency pair can also be exchanged for a financial asset like gold or oil, as long as the two have a positive correlation.
For example, the most frequently cited positive correlations are GBPUSD and EURUSD. This is due to the geographical and political alignment of the UK and EU. So, if you had a long GB/USD position, you might hedge it with a short EURUSD position.
Forex correlation hedging solutions are especially useful in volatile markets like currency trading. Due to the large number of financial instruments that have a positive correlation, pairs trading can also help you diversify your trading portfolio.
It’s vital to realize that when you use a correlative hedging approach, your exposure now covers numerous currencies. While the positive correlation works when the economies grow in lockstep, any divergence in the way each pair moves – and hence your hedging – could have an impact.
Hedging forex with options
FX options are a type of derivatives product that gives a trader the right, but not the responsibility, to purchase or sell a currency pair at a predetermined price with a future expiration date. Options are priced using market prices for currency pairs, specifically the base currency.
Assume a trader decides to buy a USDCAD call option because he believes the price will fall. He can then sell a ‘put option’ on an equal quantity of foreign currency and benefit from the price drop. This protects the trader from losses by hedging any currency risk from the decreasing position.
Forward currency contracts
A forward contract is a customized contract between two parties to buy or sell an asset at a specified price on a future date. The buyer is obligated to purchase this asset. Traders can settle forward currency contracts for cash or delivery at any time during the term of the contract, as well as change the future expiration date, the currency pair being traded, and the exact amount of money involved. Some traders favor this kind of derivative trading since it involves a lower risk, particularly when it comes to currency hedging.
Hedging with FX forwards can be a good strategy to lock in a price in advance and protect against market volatility. Aside from the fact that currency futures are traded on an exchange, hedging using them is almost comparable to hedging with forwards.
Pros of hedging
- You have control over your risk/reward ratio. A hedge acts as a helpful counterbalance to your other investments, providing price benefits even when your other positions are moving in the opposite way.
- It broadens your portfolio’s diversification. Hedging spreads out your open positions to lessen the danger of a single variable or event wiping out your entire portfolio.
- It acts as a hedge against price movements that are unpredictable. If your account experiences volatility or large price swings, your hedged position can assist preserve the total worth of your account by generating a profit on that position.
Cons of hedging
- The profit potential will almost certainly be lowered. This is because if earnings on your initial open positions continue to rise, your hedged position is likely to lose value.
- You might not have the knowledge to use hedging to your advantage. Many new forex traders lack the market knowledge and skill to execute hedges in a way that maximizes their worth due to the difficulty of constructing and timing hedges.
- In the event of unexpected volatility, your hedge may lose money as well. Hedge positions that aren’t directly linked to your other investments aren’t necessarily guaranteed to gain value as your other positions lose value.
Hedging is accomplished by purchasing an offsetting currency exposure. Hedging methods can be used on a variety of financial instruments, including forward currency contracts, correlating pairs, and FX options. Like any other trading strategy, it has its pros and cons.