Forex Hedging: What is It and How Do You Use It?
Investors of all stripes use hedging as a strategy to protect one position from adverse price movements. Typically, hedging involves the opening of a second position that is likely to have a negative correlation with the primary asset being held, meaning that if the primary asset’s price makes an adverse movement, the second position will experience a complementary and opposite movement that offsets those losses.
In forex trading, investors can use a second pair as a hedge for an existing position they’re reluctant to close out. Although hedging reduces risk at the expense of profits, it can be a valuable tool to protect profits and stave off losses in forex trading.
Basics of Forex Hedging
Forex hedging involves opening a position on a currency pair that counteracts possible movements in another currency pair. Assuming the sizes of these positions are the same and that the price movements are inversely correlated, the price changes in these positions can cancel each other out while they’re both active.
Although this eliminates potential profits during this window, it also limits the risk of losses.
The simplest form of this is direct hedging in which traders open a buy position and sell position on the same currency pair to preserve whatever profits they’ve made or prevent any further losses. Traders may take more complex approaches to hedging that leverage known correlations between two currency pairs.
How a Forex Hedge Works
The process of opening a forex hedge is simple. It starts with an existing open position—typically a long position—in which your initial trade is anticipating a move in a certain direction. A hedge is created by opening a position that runs counter to your expected movement of the currency pair, allowing you to maintain an open position on the original trade without incurring losses if the price movement goes against your expectations.
Often, this hedge is used to preserve earnings you’ve already made. The NOK/JPY chart below demonstrates a situation in which a trader might want to hedge. If, for example, they opened a long position close to the low point of that chart and capitalized on the significant gains that developed in the subsequent days, the trader may choose to open a short position to hedge against any potential losses.
Although the trader could also simply close their position and cash out their earnings, they may be interested in maintaining that open position to see how the chart patterns and technical indicators evolve over time.
In this case, the hedge can be used to neutralize potential profits or losses as the trader maintains that position and gathers more information. Even if the price plummets, they’ll be able to cash out all of the earnings they generated from that initial upswing.
Advantages of Hedging in Forex
Similar to hedging in the stock market, forex hedging provides several key benefits that experienced traders can stabilize their accounts and open positions. Those advantages include:
- You have better control over your risk/reward ratio. A hedge provides a valuable counterbalance against your other positions and can offer a ballast in the form of price gains even as other positions move in the opposite direction.
- It improves diversification of your holdings. Hedging spreads out your open positions to reduce the risk of a single variable or event hitting your positions with losses across the board.
- It acts as an insurance policy against unpredictable price swings. If volatility or sudden price swings occur, your hedged position could help preserve the overall value of your account and create a profit on that position that can stabilize your account balance until other positions increase in value.
Potential Disadvantages of Hedging in Forex
While hedging can be a very valuable strategy, it also comes with significant risk and can nullify gains and profits if you aren’t careful about how you use these hedges. The most likely disadvantages created by hedging include the following:
- Your profit potential will likely be reduced. While a hedge reduces your risk, it also cuts into your profit potential. This is because in cases where profits continue to rise for your initial open positions, your hedged position is likely to decrease in value.
- You may lack the expertise to leverage hedging to your own financial gain. Because of the complexity of creating and timing hedges, many beginning forex traders lack the market familiarity and expertise to execute hedges in a way that maximizes their value.
- It’s possible that your hedge will also lose money in the event of sudden volatility. While it may not be a common event, hedges—particularly complex hedges, which are not directly correlated to your other positions—are not always guaranteed to gain in value as other positions lose. This is because the variables and events causing these price movements cannot be fully predicted, which means the impact volatility has on your hedged position cannot be fully known. This could lead to even more significant losses than if you hadn’t hedged your position at all.
Complex Hedges in Forex
Because complex hedges aren’t direct hedges, they require a little more trading experience to effectively execute them. One approach is opening positions in two currency pairs whose price movements tend to be correlated.
Traders can use a correlation matrix to identify forex pairs that have a strong negative correlation, meaning that when a pair goes up in price, the other goes down.
The USD/CHF and EUR/USD combinations, for example, are great options for hedging because of their strong negative correlation. By opening a buy position on USD/CHF and a short on EUR/USD, traders can hedge their positions on USD to minimize their trading risk.
Trading with forex options also creates hedging opportunities that can be effective when utilized in specific circumstances. It takes an experienced trader to be able to identify these small windows of opportunity where complex hedges can help maximize profits while minimizing risk.
When to Consider Hedging
Hedges are useful whenever you’re looking to maintain an open position on a pairing while offsetting some of your risk in that situation.
A short-term hedge can be a great way to protect profits when you’re unsure of certain factors that could cause volatile price movements. This uncertainty can range from a suspicion that an asset has been overbought to concerns that political or economic instability could cause certain forex pairs to plummet in value—particularly when you’ve opened a long position on those pairs.
In the USD/JPY chart shown below, a period of consolidation is creating breakout potential that could go in either direction. If you already have an open position in this currency pair and are hoping that the price decline breaks through the resistance line, you might consider hedging with another position, targeting a rebound from the trend line back up toward previous highs.
If you do open this hedge and the price breaks through the trend line, you can always close your second position and continue reaping the profits of your successful short. But if you’re wrong and the trend reverses course, you can close both positions and still cash out your earnings from the previous price change.
Traders often use hedges to protect against the short-term volatility of economic news releases or market gaps over weekends. Traders should keep in mind that as hedging reduces trading risk, it also lowers potential profits.
Because of the low returns created by hedging, this strategy works best for traders who are working the forex market full-time or have an account that is large enough to generate big monetary gains through limited-percentage profits.
Exiting a Hedge
When you’re exiting a direct or complex hedge and keeping your initial position open, you need to close out only the second position. When you’re closing out both sides of a hedge, though, you’ll want to close these positions simultaneously to avoid the potential losses that can come if there is a gap.
It’s important to keep track of your hedged positions so that you’re able to close out the right positions at the right time to complete the execution of this strategy. Overlooking one open position in the process can derail your entire hedging strategy—and potentially hit your trading account with steep losses.
Potential Risks When Hedging
Although forex hedging is typically used to limit risk for traders, poor execution of this strategy can be disastrous for your trading account.
Due to the complexity of hedging in forex, traders—even experienced traders—can never be fully assured that their hedge will counteract any possible losses. Even with a well-designed hedge, it’s possible for both sides to generate a loss. Factors such as commissions and swaps should also be carefully considered.
Traders should not engage in complex hedging strategies until they have a strong understanding of market swings and how to time trades to capitalize on price volatility. Poor timing and complex pairing decisions could lead to rapid losses within a short period of time.
Experienced traders can use their knowledge of market swings, the factors affecting these price movements, and a strong familiarity with the forex correlation matrix to protect their profits and continue creating revenue through the use of timely forex hedges.