So, what does trimming bushes and shrubs have to do with forex? Jokes aside, the concept of hedging or ‘insuring one’s self against loss’ has existed for centuries, dating back to the times of ancient Mesopotamia.
Hence, hedging is, of course, not just exclusive to forex trading but applies to an array of financial instruments like equities, commodities, options, cryptocurrencies, and several other investing products.
Regardless of the market, the core concept remains the same – to offset potential losses or gains of an initial investment by buying or selling another asset.
Yet, as expected, hedging is also unique as it pertains to forex since we are dealing with pairs and not standalone markets.
How does hedging work in forex?
Hedging is simultaneously buying and selling two forex markets to offset any losses from your initial position. In an un-hedged trade, a trader typically executes an order with a predefined stop loss or a point where they’d close it for a loss.
Through hedging, they could essentially have a smaller net loss (or no loss) than if they didn’t hedge in the first place. Assume you opened a standard lot buy order on EURUSD with a fixed stop loss at 40 pips (where one pip equals $10); you’d stand to lose $400.
As an alternative, you decide to open a position of the same value on USDCHF with the same 40-pip stop loss size and $400 monetary loss. USDCHF is a pair often moving in the opposite direction to the euro due to historical correlation.
Let’s imagine the price moved adversely on the euro (showing a running loss). This would subsequently cause it to move in the other direction on the Swiss franc (showing a running profit).
If you decided to close both trades at once, the net outcome of your positions would effectively be zero or no loss.
The main types of hedging strategies
Broadly speaking, there are only two types of hedging strategies in forex.
- Direct hedge: This strategy involves executing two opposing positions directly on the same pair. If we revisit the euro example, instead of opening trade on USDCHF, a trader will open another trade on EURUSD.
They may use the same lot size or split it in two to not use too much margin. Like any hedging strategy, a trader will always have two or more positions going for and against them.
Hence, depending on when they choose to close their orders, the net result could be a slight loss, no loss, profit, or even a larger than expected loss depending on market conditions and trade management.
- Correlation hedge: Here, traders take advantage of positive or negative correlation by executing positions on two separate markets. In the previous example, USDCHF has an inverse price relationship to the EURUSD.
So, executing a buy or sell order on one will often offset the other. If the net outcome seems to remain the same with this strategy, how is it different from a direct hedge?
While two markets may share notable price relationships, they might not move in the same volatility range. So, another reason why someone would choose this mechanism is by exploiting a more volatile pair’s movements.
However, it takes a great understanding of correlations, and there is a more considerable risk as correlations aren’t guaranteed and can change at any time. So, for instance, rather than hedging with USDCHF, a trader may choose a pair like GBPUSD or USDCAD as both are more volatile than the euro.
So, if they closed a losing position on EURUSD, their running orders on either of these may produce a positive outcome if the price moved faster over a shorter period.
Advantages and disadvantages of hedging
Let’s consider why some traders prefer hedging and some reasons why it’s not always a good idea.
When done skillfully, traders can limit their downside to a known amount, which is the primary motivation for hedging. Adopting this approach is beneficial as traders focus more on what could go wrong than what could go right.
As previously mentioned, some instances of hedging may produce a profitable result depending on their pairs used, the position sizing parameters, market conditions, and how traders manage their trades.
One of the primary drawbacks of hedging is it usually creates scenarios where you often simultaneously eliminate some risk and also limit your upside. Let’s consider that when a trader executes one position with a fixed stop loss, their profit potential is theoretically uncapped.
They only deal with that order, and If the market goes in their favor, they don’t need to ‘micromanage’ any other extra running positions. This means there is a binary outcome of losing a set amount or some profit if the market moves favorably.
You need to predefine a point of some resulting outcome with hedging once you’ve closed all trades. In other words, hedgers will frequently have some positions going for them and some not.
‘Do I close this position or let it run? Where do I put my stop loss for the second running order if I’ve closed the original trade?’ Depending on the position sizing used and market conditions, the net outcome may not necessarily be sensible.
Moreover, if you’re using correlations, there is also the risk of it changing. So, overall, there is more micro-management with hedging.
There are other more advanced hedging techniques involving different instruments like futures/forwards and options. Futures are used more for locking in prices in advance when you expect to receive a future-dated payment in a foreign currency.
This would be to mitigate any exchange rate risks between when you enter into a futures contract and when you receive that payment. Hence, this instrument is not necessarily for retail trading purposes as with typical spot forex.
On the other hand, options are more instantly tradeable and offer traders a capped downside. An option is an instrument affording holders the right, but not the obligation, to buy or sell a pair at a set price on predefined expiry date.
So, for instance, a trader could open a buy EURUSD order in spot forex and a ‘put option’ (sell option). If the market went for them in the first position, they would only pay a premium on the option when it expired since no stop losses are used with this derivative.
Overall, hedging is one of the fundamental concepts of managing risks, which traders face daily in the markets.