Forex Hedge.
What is a 'Forex Hedge'
A forex hedge is a transaction implemented by a forex trader or investor to protect an existing or anticipated position from an unwanted move in exchange rates. By using a forex hedge properly, a trader who is long a foreign currency pair, or expecting to be in the future via a transaction can be protected from downside risk, while the trader who is short a foreign currency pair can protect against upside risk.
It is important to remember that a hedge is not a money making strategy.
BREAKING DOWN 'Forex Hedge'
The primary methods of hedging currency trades for the retail forex trader is through spot contracts and foreign currency options. Spot contracts are the run-of-the-mill trades made by retail forex traders. Because spot contracts have a very short-term delivery date (two days), they are not the most effective currency hedging vehicle. In fact, regular spot contracts are often why a hedge is needed.
Foreign currency options are one of the most popular methods of currency hedging. As with options on other types of securities, foreign currency options give the purchaser the right, but not the obligation, to buy or sell the currency pair at a particular exchange rate at some time in the future. Regular options strategies can be employed, such as long straddles, long strangles, and bull or bear spreads, to limit the loss potential of a given trade. (See also: Getting Started In Forex Options )
Forex Hedge Example.
For example, if a U. S. company was scheduled to repatriate some profits earned in Europe it could hedge some, or part of the expected profits through an option. Because the scheduled transaction would be to sell euro and buy U. S. dollars, the company would buy a put option to sell euro. By buying the put option the company would be locking in an 'at-worst' rate for its upcoming transaction, which would be the strike price. And if the currency is above the strike price at expiry then the company would not exercise the option and do the transaction in the open market.
Not all retail forex brokers allow for hedging within their platforms. Be sure to research the broker you use before beginning to trade.
What is hedging as it relates to forex trading?
When a currency trader enters into a trade with the intent of protecting an existing or anticipated position from an unwanted move in the foreign currency exchange rates, they can be said to have entered into a forex hedge. By utilizing a forex hedge properly, a trader that is long a foreign currency pair, can protect themselves from downside risk; while the trader that is short a foreign currency pair, can protect against upside risk.
The primary methods of hedging currency trades for the retail forex trader is through:
Spot contracts are essentially the regular type of trade that is made by a retail forex trader. Because spot contracts have a very short-term delivery date (two days), they are not the most effective currency hedging vehicle. Regular spot contracts are usually the reason that a hedge is needed, rather than used as the hedge itself.
A forex hedging strategy is developed in four parts, including an analysis of the forex trader's risk exposure, risk tolerance and preference of strategy. These components make up the forex hedge:
Analyze risk: The trader must identify what types of risk (s)he is taking in the current or proposed position. From there, the trader must identify what the implications could be of taking on this risk un-hedged, and determine whether the risk is high or low in the current forex currency market.
The forex currency trading market is a risky one, and hedging is just one way that a trader can help to minimize the amount of risk they take on. So much of being a trader is money and risk management, that having another tool like hedging in the arsenal is incredibly useful.
How to use a Forex hedging strategy to look for lower-risk profits.
If we had to sum up hedging in as few a words as possible, we could probably trim it down to just two:
That, in essence, is the thinking behind all hedging strategies.
The classic definition of a hedge is this:
. a position taken by a market participant in order to reduce their exposure to price movements.
For example, an airline is exposed to fluctuations in fuel prices by the inherent cost of doing business.
Such an airline might choose to buy oil futures in order to mitigate against the risk of rising fuel prices.
Doing so would allow them to focus on their core business of flying passengers.
They have hedged their exposure to fuel prices.
For a fuller explanation about this kind of hedging, take a look at our article explaining what Forex hedging is.
In this sense, a hedger is the opposite of a speculator.
The hedger takes a position to reduce or remove risk, as we have said.
This is in contrast to a speculator, who takes on price risk in the hopes of making profit.
But is there a way to have your cake and eat it?
Are there no loss Forex hedging strategies and techniques where you take positions with the intention of profit, but also mitigate your risk?
While it's not truly possible to remove all risk, the answer is yes.
There is a number of different Forex hedging strategies that aim to do this to varying degrees.
The real trick of any Forex hedging technique and strategy is to ensure the trades that hedge your risk don't wipe out your potential profit.
The first Forex hedge strategy we're going to look at seeks a market-neutral position by diversifying risk.
This is what I call the hedge fund approach .
Because of its complexity, we aren't going to look too closely at the specifics, but instead discuss the general mechanics.
Market-neutral position through diversification.
Hedge funds exploit the ability to go long and short in order to seek profits while only being exposed to minimal risk.
At the heart of the strategy is targeting price asymmetry.
Generally speaking, such a strategy aims to do two things:
stave off exposure to market risk by trading in multiple, correlated instruments exploit asymmetries in price for profit.
The strategy relies on the assumption that prices will eventually revert to the mean, yielding a profit.
In other words, this strategy is a form of statistical arbitrage.
The trades are constructed so as to have an overall portfolio that is as market-neutral as possible.
That is to say, that price fluctuations have little effect on the overall profit and loss.
Another way of describing this is that you are hedging against market volatility.
A key benefit of such strategies is that they are intrinsically balanced in nature.
In theory, this should protect you against a variety of risks.
In practice, however, it is very hard to constantly maintain a market-neutral profile.
Well, correlations between instruments may be dynamic, for a start.
Consequently it is a challenge simply to stay on top of measuring the relationships between instruments.
It is a further challenge to act on the information in a timely manner and without incurring significant transaction costs.
Hedge funds tend to operate such strategies using large numbers of stock positions.
With stocks, there are clear and easy commonalities between companies that operate in the same sector.
Identifying such close commonalities with currency pairs is not so easy.
Furthermore, there are fewer instruments to choose from.
The good news is that MetaTrader 4 Supreme Edition comes with a Correlation Matrix, along with a host of other cutting-edge tools.
This makes it easier to recognise close relationships between pairs.
Using options trading in hedging strategy.
Another way to hedge risk is to use derivatives that were originally created with this express purpose.
Options are one of these types of derivative and they make an excellent tool.
An option is a type of derivative that effectively functions like an insurance policy.
As such, it has many uses when it comes to hedging strategies.
Options are a complex subject, but we'll try to keep this to a basic level.
. in order to discuss how they can help with our foreign exchange hedging strategies, we need to introduce some options terminology.
First of all, let's define what an option is.
An FX option is the right but not the obligation to buy or sell a currency pair…
. at a fixed price at some set date in the future.
The right to buy is called a call option.
The right to sell is called a put option.
The fixed price at which the option entitles you to buy or sell is called the strike price or exercise price .
The set date in the future is called the expiry date .
. a 1.2900 GBP/USD call is the right to buy one lot of GBP/USD at 1.2900.
The price or premium of an option is governed by supply and demand, as with anything traded in a competitive market.
We can, however, consider the value of an option to consist of two components:
An option's intrinsic value is how much it is worth if exercised in the market.
A call will only have intrinsic value if:
. its exercise prices is less than the current price of the underlying.
The opposite is true for a put option.
A put will only have intrinsic value if:
. its exercise price is greater than the current price of the underlying.
An option with intrinsic value of more than 0 is said to be in the money .
If an option's intrinsic value is 0, it is said to be out of the money .
An option's price will often exceed its intrinsic value, though.
An option offers protective benefits to its buyer.
Because of this, traders are willing to pay an added amount of time value.
All things being equal, the more time left to an option's expiry, the greater its time value.
Consider our 1.2900 GBP/USD call.
The spot GBP/USD rate is the underlying market.
If the underlying is trading at 1.2730, for example, our call is out of the money.
Its intrinsic value is 0.
However, if GBP/USD is trading at 1.3050, our call option has an intrinsic value of 150 pips.
That's because if we exercised the option, we could buy GBP/USD at 1.2900, the exercise price of our call.
This would allow us to sell at the underlying price of 1.3050 for a profit of 150 pips.
Having run through these basics…
. let's now look at how we can use options as part of a Forex hedging strategy protection against losses.
The interesting thing about options is the asymmetrical way in which their price changes as the market goes up or down.
A call option will increase in value as the market rises with no ceiling.
But if the market falls, the call's premium can go no lower than 0.
This means if you bought the call, you have unlimited upside with a strictly limited downside.
This opens the door to a wealth of possibilities when it comes to your hedging Forex strategy.
Let's look at a simple example:
. buying an option as a protection against price shocks.
Let's say you are long AUD/USD.
You've taken the position to benefit from the positive interest rate differential between Australia and the US.
For example, if the long SWAP value is +0.17 pips, this means that:
…every day you are long the trade, you are gaining interest.
However, holding the position also exposes you to price risk.
If the currency pair moves sideways, or better rises, you are going to be fine.
But if its net movement is downward more than an average of 0.17 pips per day, you are going to make a loss.
Your real concern is a sharp drop, which could significantly outweigh any gains from the positive SWAP.
So how to mitigate this price risk?
One of the easier ways is to buy an AUD/USD put that is out of the money.
Because the option is out of the money, its premium will only consist of time value.
The further out of the money, the cheaper the premium you will have to pay for the put.
The risk profile of a put is that you have a fixed cost i. e. the premium you pay to buy the put.
But once you have paid this, it provides protection against sharp downward movements.
Let's work through some numbers.
Let's say you bought one lot of AUD/USD on 9 September when the price was 0.7600.
You took the long position as a carry trade to benefit from the positive swap.
However, you want to protect yourself against the risk of a sharp move to the downside.
You decide that the best way to hedge the risk is to buy an out of the money put option.
You buy the 0.7500 put with a one-month expiry at a price of 0.0061.
At expiry, the 0.7500 put will be worth something if the underlying has fallen below 0.7500.
By buying the put, you have reduced your maximum downside on your long trade to just 100 pips.
That's because the intrinsic value of your put starts increasing once the market drops below its exercise price.
Your overall downside is:
. the 100 pips between your long position and the exercise price, plus the cost of the put.
In other words, a total of 161 pips.
The diagram below shows the performance of the strategy against price at expiry:
You can think of the option's cost as equivalent to an insurance premium.
Following on from this analogy:
. the difference between the exercise price and the level at which you are long the underlying is a bit like a deductible of the insurance policy.
Want to know the best bit?
Your upside has no limit.
As long as AUD/USD keeps rising, you will keep making profit.
To continue our example:
. let's say AUD/USD plummets to 0.7325 at expiry.
You will have lost 275 pips on your long position.
But your put, the right to sell AUD/USD at 7500, must be worth 175 pips.
Therefore, you have lost only 100 pips.
Add in the 61 pip cost of the option's premium in the first place, and your total downside is 161 pips, as stated above.
No matter how far AUD/USD drops, this number never increases.
Now consider, AUD/USD rising to 7750 at expiry.
You make 150 pips on your long position, but your option costs 61 pips.
Overall, you make the difference, which is 89 pips of profit.
A final word on Forex hedging strategies and techniques.
Hedging is always something of a balancing act.
The act of hedging delays the risk, but the compromise is in how this affects your potential profit.
As stated earlier, some market participants hedge in order to completely reduce their risk.
They are happy to give up their chance of making a speculative profit in exchange for removing their price exposure.
Speculators are not entirely happy doing this.
The best forex hedging strategy for them will likely:
retain some element of profit potential contain some tradeoff in terms of reduced profit in exchange for downside protection.
Options are an extremely useful tool for hedging, as we saw from our example.
Their complexity, though, means they are better suited to traders with more advanced knowledge.
Options offer the versatility to set up a variety of hedging strategy Forex risk profiles.
This allows you to fully tailor your best Forex hedge strategy to properly suit your attitude to risk.
If you want to practise different Forex hedging strategies, trading on a demo account is a good solution.
Because you are only using virtual funds, there is no risk of an actual cash loss and you can discover how much risk suits you personally.
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Forex Hedging: How to Create a Simple Profitable Hedging Strategy.
Ultimately to achieve the above goal you need to pay someone else to cover your downside risk.
In this article I’ll talk about several proven forex hedging strategies. The first section is an introduction to the concept which you can safely skip if you already understand what hedging is all about.
The second two sections look at hedging strategies to protect against downside risk. Pair hedging is a strategy which trades correlated instruments in different directions. This is done to even out the return profile. Option hedging limits downside risk by the use of call or put options. This is as near to a perfect hedge as you can get, but it comes at a price as is explained.
What Is Hedging?
Hedging is a way of protecting an investment against losses. Hedging can be used to protect against an adverse price move in an asset that you’re holding. It can also be used to protect against fluctuations in currency exchange rates when an asset is priced in a different currency to your own.
When thinking about a hedging strategy it’s always worth keeping in mind the two golden rules :
Hedging might help you sleep at night. But this peace of mind comes at a cost. A hedging strategy will have a direct cost. But it can also have an indirect cost in that the hedge itself can restrict your profits.
The second rule above is also important. The only sure hedge is not to be in the market in the first place. Always worth thinking on beforehand.
Simple currency hedging: The basics.
The most basic form of hedging is where an investor wants to mitigate currency risk. Let’s say a US investor buys a foreign asset that’s denominated in British pounds. For simplicity, let’s assume it’s a company share though keep in mind that the principle is the same for any other kind of assets.
The table below shows the investor’s account position.
Without protection the investor faces two risks. The first risk is that the share price falls. The second risk is that the value of the British pound falls against the US dollar. Given the volatile nature of currencies, the movement of exchange rates could easily eliminate any potential profits on the share. To offset this, the position can be hedged using a GBPUSD currency forward as follows.
In the above the investor “shorts” a currency forward in GBPUSD at the current spot rate. The volume is such that the initial nominal value matches that of the share position. This “locks in” the exchange rate therefore giving the investor protection against exchange rate moves.
At the outset, the value of the forward is zero. If GBPUSD falls the value of the forward will rise. Likewise if GBPUSD rises, the value of the forward will fall.
The table above shows two scenarios. In both the share price in the domestic currency remains the same. In the first scenario, GBP falls against the dollar. The lower exchange rate means the share is now only worth $2460.90. But the fall in GBPUSD means that the currency forward is now worth $378.60. This exactly offsets the loss in the exchange rate.
Note also that if GBPUSD rises, the opposite happens. The share is worth more in USD terms, but this gain is offset by an equivalent loss on the currency forward.
In the above examples, the share value in GBP remained the same. The investor needed to know the size of the forward contract in advance. To keep the currency hedge effective, the investor would need to increase or decrease the size of the forward to match the value of the share.
As this example shows, currency hedging can be an active as well as an expensive process.
Hedging Strategy to Reduce Volatility.
Because hedging has cost and can cap profits, it’s always important to ask: “why hedge”? For FX traders, the decision on whether to hedge is seldom clear cut. In most cases FX traders are not holding assets, but trading differentials in currency.
Daily pips.
Essential for anyone serious about making money by scalping. It shows by example how to scalp trends, retracements and candle patterns as well as how to manage risk. It shows how to avoid the mistakes that many new scalp traders fall into.
Carry traders are the exception to this. With a carry trade, the trader holds a position to accumulate interest. The exchange rate loss or gain is something that the carry trader needs to allow for and is often the biggest risk. A large movement in exchange rates can easily wipe out the interest a trader accrues by holding a carry pair.
More to the point carry pairs are often subject to extreme movements as funds flow into and away from them as central bank policy changes (read more).
To mitigate this risk the carry trader can use something called “reverse carry pair hedging”. This is a type of basis trade. With this strategy, the trader will take out a second hedging position. The pair chosen for the hedging position is one that has strong correlation with the carry pair but crucially the swap interest must be significantly lower.
Carry pair hedging example: Basis trade.
Take the following example. The pair NZDCHF currently gives a net interest of 3.39%. Now we need to find a hedging pair that 1) correlates strongly with NZDCHF and 2) has lower interest on the required trade side.
Using this free FX hedging tool the following pairs are pulled out as candidates.
The tool shows that AUDJPY has the highest correlation to NZDCHF over the period I chose (one month). Since the correlation is positive, we would need to short this pair to give a hedge against NZDCHF. But since the interest on a short AUDJPY position would be -2.62% it would wipe out most of the carry interest in the long position in NZDCHF.
The second candidate, GBPUSD looks more promising. Interest on a short position in GBPUSD would be -1.04%. The correlation is still fairly high at 0.7137 therefore this would be the best choice.
We then open the following two positions:
The volumes are chosen so that the nominal trade amounts match. This will give the best hedging according to the current correlation.
Figure 1 above shows the returns of the hedge trade versus the unhedged trade. You can see from this that the hedging is far from perfect but it does successfully reduce some of the big drops that would have otherwise occurred. The table below shows the month by month cash flows and profit/loss both for the hedged and unhedged trade.
Carry hedging with options.
Hedging using an offsetting pair has limitations. Firstly, correlations between currency pairs are continually evolving. There is no guarantee that the relationship that was seen at the start will hold for long and in fact it can even reverse over certain time periods. This means that “pair hedging” could actually increase risk not decrease it.
For more reliable hedging strategies the use of options is needed.
Buying out of the money options.
One hedging approach is to buy “out of the money” options to cover the downside in the carry trade. In the example above an “out of the money” put option on NZDCHF would be bought to limit the downside risk. The reason for using an “out of the money put” is that the option premium (cost) is lower but it still affords the carry trader protection against a severe drawdown.
Selling covered options.
As an alternative to hedging you can sell covered call options. This approach won’t provide any downside protection. But as writer of the option you pocket the option premium and hope that it will expire worthless. For a “short call” this happens if the price falls or remains the same. Of course if the price falls too far you will lose on the underlying position. But the premium collected from continually writing covered calls can be substantial and more than enough to offset downside losses.
If the price rises you’ll have to pay out on the call you’ve written. But this expense will be covered by a rise in the value of the underlying, in the example NZDCHF.
Hedging with derivatives is an advanced strategy and should only be attempted if you fully understand what you are doing. The next chapter examines hedging with options in more detail.
Downside Protection using FX Options.
What most traders really want when they talk about hedging is to have downside protection but still have the possibility to make a profit. If the aim is to keep some upside, there’s only one way to do this and that’s by using options .
When hedging a position with a correlated instrument, when one goes up the other goes down. Options are different. They have an asymmetrical payoff. The option will pay off when the underlying goes in one direction but cancel when it goes in the other direction.
First some basic option terminology. A buyer of an option is the person seeking risk protection. The seller (also called writer) is the person providing that protection. The terminology long and short is also common. Thus to protect against GBPUSD falling you would buy (go long) a GBPUSD put option. A put will pay off if the price falls, but cancel if it rises.
On the other hand if you are short GBPUSD, to protect against it rising, you’d buy a call option.
For more on options trading see this tutorial.
Basic hedging strategy using put options.
Take the following example. A trader has the following long position in GBPUSD.
The price has already fallen since he entered so the position is now down by $70.
The trader wants to protect against further falls but wants to keep the position open in the hope that GBPUSD will make a big move to the upside. To structure this hedge, he buys a GBPUSD put option. The option deal is as follows:
Trade: Buy 0.1 x GBPUSD put option.
The put option will pay out if the price of GBPUSD falls below 1.5000. This is called the strike price . If the price is above 1.500 on the expiry date, the put option will expire worthless.
The above deal will limit the loss on the trade to 100 pips. In the worst case scenario the trader will lose $190.59. This includes the $90.59 cost of the option. The upside profit is unlimited.
The option has no intrinsic value when the trader buys it. This is an “out of the money” option. The time value, or premium is there to reflect the fact that the price may fall and the option could therefore go “in the money”.
The trader pays $90.59 for this privilege of gaining downside protect. This premium goes to the seller of the option (the writer).
Note that the above structure of a put plus a long in the underlying has the same pay off as a long call option.
The table above shows the pay outs in three different scenarios: Namely the price rising, falling or staying the same. Notice that the price has to rise slightly for the trader to make a profit in order to cover the cost of the option premium.
To help you test the trading ideas presented here the following free downloads are provided:
Want to stay up to date?
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A basic credit spread involves selling an out-of-the-money option while simultaneously purchasing a. How to Create an Option Straddle, Strangle and Butterfly.
In highly volatile and uncertain markets that we are seeing of late, stop losses cannot always be relied. Spread Trading and How to Make it Work.
If you find yourself repeating the same trades day-in and day-out – and a lot of active traders do. FX Derivatives: Using Open Interest Indicators.
Currency forwards and futures are where traders agree the rate for exchanging two currencies at a given.
Hi Seyedmajid – is it possible to share your experiences.
i have made a winning hedging strategy that always make profit no matter where market is going…
this is my ultimate strategy after 8 years of trading.
can you share bro.
super article on hedging and thoroughly explained.. thanks steve.
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