The Fundamentals Forex Hedging Strategy
Trading on a volatile forex market is risky. However, forex hedging can protect you from a significant loss in a specific market position. It is usually insurance on your trading. Hedging cannot eliminate the loss entirely but ensures a comprehensive reduction. However, you may take a different forex hedging strategy according to your broker’s policy and your experience level.
So, which strategy you should take, and how should you initiate it?
You will know them in this article with the ins and out of hedging in FX.
What is Forex Hedging?
Forex hedging is a way to protect a position against any adverse movement by opening an additional position. However, hedging itself buys or sells financial instruments to balance the current positions so that the risk of exposure gets reduced. All traders and investors always seek to find possible ways to limit any potential risk related to exposure, and hedging is a strategy that works perfectly.
However, hedging in FX is used by different investors, market participants, businesses, and traders. With the proper use of hedging, a trader can get protection from the downside risk while on a long currency pair. On the other hand, for the short currency pair, the investor can protect himself against the upside risk through the forex hedge.
Understanding a Hedging Techniques
You should keep in mind that you should not consider hedge as a money-making strategy. It works towards protecting from any potential losses; however, it doesn’t help you make a profit. Furthermore, most hedges’ task is to eliminate the exposure risk of a portion instead of the whole part of it.
Forex Hedging Example
Understanding the forex hedging could be tricky, but explaining it with an example may clear the hedging idea. Here this easy example should make you understand hedging techniques.
Let’s say a Japanese company will sell some equipment in US dollars. Now, the Japanese company may protect a part of the transaction by taking out a specific currency option, which will generate profit if the value of the Japanese yen increases against the dollar. So, if the transaction occurs unprotected and the value of the dollar increases or ever stays stable, the company will get the protection for only taken out currency options. However, if the dollar loses stability, the currency option’s profit can balance some losses.
Why should you hedge in forex?
A trader should go for a hedge is an effective method to protect themselves against any unwanted exchange rate fluctuation. However, it would not give you the elimination of the entire risk, but it surely saves a portion of the transaction from loss.
Forex hedging is different from hedging in other markets, as forex trading is volatile by nature. However, some brokers may not support hedging by considering the volatility as a part of trading and eventually want to take the maximum risk.
So, suppose you assume that a currency pair may decline in value soon, but the trend reverses immediately. In that case, the forex hedging strategy will reduce your short-term losses but protect your long-term profits.
Forex Hedging Strategy
Numerous forex hedging strategy are available in the forex market, but the traders commonly use only three strategies depending on the experience and the forex hedging broker’s policy.
Simple Forex Hedging
It is commonly known as direct hedging. However, it is a widely used strategy and easy to apply. Simple forex hedging takes place when you open a position intending to buy a currency pair and then open the mirror position to sell that specific currency. It may happen for a long and short position.
Traders may do this for numerous reasons. When you take the simple strategy, you have two open positions but in opposite directions exactly. However, you cannot make a profit on the original hedge, but it can keep your original position. As a result, you don’t need to close your actual position and make a loss. But you can make money via the short position. However, the original position’s maintenance gives you the opportunity to make a profit if the market goes reverse.
Multiple Currency Hedging
It is a bit complex forex hedging strategy. Multiple currency hedging is effective for trading multiple currency pairs. Usually, this strategy occurs when you take a long position on multiple currencies but offset a short position on one of those placed positions.
This strategy will be clear if you look at the following example.
Suppose you have taken a long position for GBP/USD pairs and placed a short position for USD/JPY. So, your USD exposure is protected to a high degree. However, this strategy cannot cove the movements for other currencies. So, if the GBP or JPY fluctuates, you have a possibility to get exposed.
Moreover, traders also consider positively correlated currencies to take a short and long position. So, if a currency pair falls, the other pair will go up. EUR/USD, also the GBP/USD are perfect examples of correlated currencies.
Forex Option Hedging
Usually, an option in forex trading means the agreement to exchange in the future at a specific price decided now. However, it is a very common instrument for forex traders who want to hedge their positions.
For example, you have placed a long position on EUR/USD at $1.07 and expect this to go higher. But, somehow, you come to know that the price may fall due to the upcoming release of economic data. To reduce the risk, you can put an option defining a strike of $1.06 on that pair and set the expiration date after the data release.
Later, if the price goes lower, the payment will be paid according to the contract condition. On the other hand, if the released economic data doesn’t affect the price and goes up, a trader can still hold the position but will lose the premium set in the forex options hedging contract.
These FX hedging strategies can give advantages to the broker in real-time. However, you must need a good forex hedging broker to apply them all.
Forex Hedging Techniques
Forex hedging is not an easy task to do. Therefore, the advanced traders apply to hedge as they contain an in-depth knowledge of the forex market. However, it doesn’t deny either, if you are new to the trading world. But, creating your own trading plan and making FX hedging strategies accordingly is necessary.
Choosing the right currency pair to the trader is the most important step for forex hedging techniques. However, choosing the currencies is totally up to you, but major forex currencies can get you more options for hedging than minor.
However, the volatility is relative, which depends on the currency pair’s liquidity. So, if you want to take any decision regarding forex hedging, it should be done on a currency-by-currency. Besides, you will need to consider the available capital and the time you seek to monitor the market.
Start Forex Hedging
Before going for a serious hedging strategy, you can try that out in a risk-free environment via a forex demo account. All the forex trading platforms offer a demo account, and you can take the benefits of it. After you get the successful strategy, you may go for the live account and apply the hedging. However, it is always recommended that you sign up with the best forex broker to get a positive result from hedging.
Hedging with a Robot
It is not worthy of hedging manually every time, as most forex hedging broker offer automated tools or robots for hedging in FX. You will just need to set up the process once, and it will work automatically.
A forex hedging robot can open several additional positions to buy and sell simultaneously. This can help you to protect yourself from unexpected and sudden market movements. However, you should understand the FX hedging strategies to command the robot according to your needs.
How to Undo a Forex hedging?
After placing a hedge¸, if you find that the market is affecting adversely, you can place a stop-loss to undo a hedge. Besides, you can close the hedging process too.
However, it depends on the forex hedging broker you are trading with, as some brokers may not permit the traders to hold a direct hedge position.
Who Hedges Forex?
In general, any trader can hedge forex as long as the broker allows it. So, it is better to find out the broker that offers to hedge if you intend to do it. To find out one, you may look for the top 10 forex brokers with hedging options.
Fees and Costs for Hedging in FX
Although no direct fees are related to forex, it depends on the broker, as policies may vary. However, you may need to pay commission or spreads depending on the instrument and situation. Besides, swap fees may incur for overnight holding.
Conclusion
The ultimate goal of forex hedging is to reduce the risk in the uncertain forex market. However, hedging in FX is a complex technique, which needs some expertise. So, it would be better if you understand the market and choose the currency pair accordingly. Moreover, you testing the hedging strategy via a demo account is a good idea to get the most out of it.
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