What is Hedging?
Hedging is a common strategy in the financial markets. To hedge is to essentially reduce your exposure to adverse market movements, but hedging also provides some unique opportunities for profit as well.
How does hedging work?
One of the major reasons that have compelled businesses to hedge against price fluctuations is that they constantly face threats that are peripheral to the central business wherein they operate.
For instance, an investor purchases the stock of pulp and Paper Company so that he is able to gain from its management. The investor does not purchase the stock in order to benefit from the opportunity of a declining dollar. However, he is aware that the company exports above 75% of its amenities to overseas markets. This is what is known as the insurance argument that works in favor of hedging. In the same manner, businesses are likely to take out insurance against their publicity to the effects of theft or fire.
In another instance, a wheat farmer may sell wheat futures to offset an anticipated decline in wheat prices. The farmer knows that if wheat prices do fall he will get less for his wheat when he goes to market. He also knows that if wheat prices fall he will profit from selling wheat futures as the price declines. In this way, he is able to offset some of the income he lost because of declining wheat prices.
Hedging is not merely an exercise nor is it a concept that is easy to be pinned down to one point. It has objectives that vary extensively from one business — or even one market — to the other.
Forex hedging is a tactic used by some traders to protect an existing or planned position from negative price movements. Correct use of hedging allows traders with a long position on a currency pair to protect themselves from a price fall and vice versa. In a sense it is like insurance; you are taking out a position that will pay you if the worst happens. However, it is more flexible — and therefore more complex — than insurance.
Forex hedging strategies have four steps. It is important to go through each step carefully because the effect of making a mistake will almost certainly be that you have less protection or higher costs than you anticipated.
Analyze your risk
The first step is to calculate the risk that your current or planned position is subject to and whether it is too high for the current market. This may have altered since you opened the position.
Consider risk tolerance
This relates to your own risk tolerance. This should not depend on your current fears or other feelings but is at a level that would apply in any similar situation. The aim of hedging is not to reduce the risk to zero but to remove what you cool-headedly consider to be an excess risk.
Decide on your Forex hedging strategy
Considering the cost of various possible hedging strategies using spot or currency options, determine which is the most effective. Let’s take a look at some of the common Forex hedging strategies.
- Trading the same currency pair more than once –– A trader will establish a long position in the EUR/USD, for example. The trader may also establish a short position in the EUR/USD. Traders using these methods anticipate that the EUR/USD may not immediately go in their direction and they may be able to grab 10, 20, or 30 pips from selling the EUR/USD before the market goes in their direction.
If the trader is able to grab a 30 pip profit on the downside before the market goes up they have just added 30 pips to their bottom line. If the trader is able to grab a 30 pip profit on the downside and the market continues downward they have effectively offset their total loss by 30 pips.
- Hedge using 2 or more different Forex pairs– To do this requires knowledge of the correlations between the currency pairs involved. “Correlation” is just another way to say, “co-relation” or how the currency pairs relate to each other. For instance, does one currency pair’s price consistently go up when another currency pair’s price consistently goes down? Those 2 currency pairs could be said to have a strong correlation. Once you know the correlations between currency pairs you can then construct an effective hedging strategy.
When you find 2 currency pairs with a strong correlation you can use the same strategy as previously described using the EUR/USD. If they have a strong positive correlation, that means that they basically move in the same direction. You can buy Forex pair A and sell currency pair B each time you feel that currency pair A might move downward in price.
Go ahead and act on your chosen strategy. Be sure to monitor it through any market changes that may affect the need for it or its effectiveness.
Hedging strategies in Forex trading can be used in any timeframe. One important thing to keep in mind is that by trading more than one currency pair you will have increased transaction costs. Just make sure that your strategy is one that will allow you to be profitable after all costs are taken into consideration.