When done correctly, hedging is a great method to help protect your position(s) against big price fluctuations. This post will delve further into hedging and discuss how you can use it to not only protect your position(s) but also how to potentially use it to your advantage in turning losing positions into profit-taking opportunities.
What is hedging in Forex?
Hedging implies protection against the risk of future price fluctuations for assets arranged in advance. It is a financial strategy used to protect a trader from losing trades resulting from adverse moves in currency pairs. Hedging is used in almost all types of financial industries; however, it has a more specific form in the foreign exchange market.
Direct Hedging
Direct hedging in forex normally takes place by the trader opening a position in the opposite direction of an existing trade. This is done in order to reduce the risk exposure of the existing position. Normally, the trader or investor carries out his or her risk analysis and quantifies the risk levels involved before instituting both the original and hedged trades. They would subsequently be responsible for controlling the level of change in their positions that takes place due to the ensuing price volatility of the market instrument(s) being traded.
For example, let's assume you open a sell position on GBPUSD, and while your position is running, the market suddenly goes up, so now your open P&L (profit and loss) number is going down. Let's continue to assume that you are still confident in the original sell position; however, you are wary that the market is likely to experience adverse price movements. To prepare for this, you open a buy position to fully hedge the trade. In a fully hedged trade, the P&L number will not move because there is both a buy and sell position open. Now that the trade is fully hedged, if the market continues to go up, the trade's buy position will continue to profit while the sell position will continue to take a loss. However, if the market reaches a resistance level, you can exit the buy position at a profit and hold the original sell position while the market comes back to your original entry point. While many traders would close out the initial position and accept any losses, a direct hedge would allow you to profit from the second trade, which would avoid the loss.
To get a further understanding, let's see this in the example below.
Hedging with multiple currencies
Another strategy would be for a trader to utilise two different currency pairs that are highly correlated, either in a positive sense or a negative sense. For example, a long trade can be opened for the USDJPY currency pair, and a short trade can be opened for its USDCHF counterpart. Because it is highly likely that both pairs move in the same direction due to the USD factor, any drawdown or loss on one of the trades would be made up for by gains and profits in the other trade.
Though the risk is usually mitigated with this hedging strategy, for this method to work successfully with different currency pairs, it is essential that the trader does his or her research on both pairs involved in the potential hedge to ensure that the correlation is high between them through their respective movements in the market. This is to guarantee that when market volatility does ensue, whether it is based on a news update such as a major central bank meeting or some other unexpected event, then the two current pairs in question will move as expected in the market.
Hedging with commodities
Commodities are popular to hedge with because they are usually seen as safe haven products.
Gold is usually the go-to product hedge for traders who especially want to protect themselves from rising inflation. When inflation becomes uncontrollable, gold prices tend to rise. Gold, in contrast, is a hedge against a lower US currency. In other words, gold prices and the US dollar tend to have an opposite relationship. When gold prices rise, the US dollar tends to fall, and vice versa. Gold has long been seen as a form of currency, which is why it's a strong hedge against a dollar crash or hyperinflation.
Another popular commodity to hedge with is oil. Some currencies are particularly vulnerable to the impact of oil prices (these forex pairs are commonly known as 'commodity pairs'). Both the Canadian dollar and the Australian dollar are notable examples. The price of oil and the exchange values of the Canadian dollar and Australian dollar usually have an inverse relationship. When the price of oil rises, the USD/CAD and AUD/USD exchange rates tend to fall, and vice versa.
You can use the oil hedging approach to hedge your USD/CAD and AUD/USD trade risk in this scenario. For example, you can go short AUD/USD and long oil as a hedging position, and vice versa.
Advantages and Disadvantages
There are significant advantages and disadvantages to engaging in hedging activities in forex:
Advantages
The biggest advantage is that it protects the trader against unpredictable price movements. If your account experiences high volatility or unexpected price swings, your hedged position may be able to help protect the total worth of your account by generating a profit on that position, which can help stabilise your account balance until the other position gains value. In other words, hedging gives the opportunity to profit on a position that would maintain the account balance during a volatile or unexpected price swing before a reversal takes place, leading to other positions going back to their original value.
When hedging is incorporated properly, your risk-reward ratio is better within your control. This is because a hedge acts as a helpful counterbalance to your other position(s), thus providing support in the form of price gains even when your other position(s) are moving in the opposite direction.
Hedging can broaden your portfolio's diversification. If you are hedging multiple products, this can spread out your open positions to reduce the chance of a single variable or event wiping out all of your positions.
Disadvantages
On the other hand, a hedge can also very likely reduce the potential for profit. If a trader has an open position in profit and the price continues to move in a certain direction after the trader implements a hedged trade in the opposite direction, then the hedged trade would be at a loss, nullifying the gains made by the original trade after the hedged trade was opened. Additionally, traders must be aware of additional trading costs such as commissions and overnight swap charges (if the hedge is held overnight).
To add, hedging is not an ideal practice for beginners in trading, as it requires the proper practice and education needed to handle opposing trades at the same time in what could be an unfamiliar market, reflecting both the numerical and positional complexities of the hedging mechanic. There is also the risk of hedging, resulting in increased losses to the trader's account due to some hedged trades not being correlated directly to initial positions; this could be because of leverage, margin, or other reasons. This has the potential for huge drawdowns in the overall position when price volatility ensues.
Another disadvantage is that, unfortunately, not all forex brokers or trading providers offer the hedging function to their traders, so traders will usually have to inquire if this function is possible before proceeding to trade with the respective broker or provider.
While you can make money from hedging, it is very important to note that before that, forex hedging should first be about mitigating risks. A trader's primary aim when hedging should always be to protect their capital against adverse moves in the currency markets. Hedging can also be very complex and costly, especially if the trader does not have much experience with this trading method, so it is not recommended to use this method in a live trading environment until you understand the mechanics of hedging, as it requires a great deal of planning and understanding.
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