Hedging is not just a strategy but a risk management tool for trading in a large financial market. Almost every trader has heard about the forex hedging strategy. But only a few have a clear idea of what actually the strategy is.
Market Investopedia wants our audience to know about different ways to trade forex. So, in this blog, we will have an overview of currency hedging, how to use it, and find out its suitability for beginners.
What is Hedging?
Hedging is a strategy that protects traders from currency price fluctuation risk. It is an arrangement made by traders to protect themselves from future currency exchange rate fluctuation.
In the forex market, a currency value can see a rise or fall depending on the market condition. In order to stay unaffected by these changes, many traders use FX hedging strategies.
Basically, hedging is insurance against foreign exchange risk. From big market participants such as central banks and multinational corporations to small participants such as retail forex traders, all use forex hedging.
How Forex Hedging Works?
The concept of forex hedging is quite simple. Under this, hedgers take advantage of forex market correlations. In order to deal with a risk associated with one currency pair, traders can open positions in correlated pairs.
Suppose a trader has opened a long position in EUR/USD. Now, the trader can hedge risk in two ways:
- The first option is opening a short position in the same pair or a positively correlated pair. GBP/USD, AUD/USD, and NZD/USD have positive correlations with EUR/USD. So the trader can consider them.
- Second, opening a long position in the pair with a negative correlation with EUR/USD. So, if the value of EUR/USD falls, the other pair will see a rise, and the trader remain unaffected by its decline. In this case trader can choose the USD/JPY and USD/CHF pair, which have a negative correlation with EUR/USD.
Is Forex Hedging is ideal for beginner:
Undoubtedly hedging is a good strategy for beginners. Many people think that hedging is just for big market players, but that’s not true. Even beginners can benefit from this style. Here is how:
A quick glance
In order to clarify, the United States does not prohibit all types of hedging; nonetheless, the primary focus of the law is on the purchasing and selling of the same currency pair at strike prices that are either the same or different from one another. As a result, the Commodity Futures Trading Commission (CFTC) has imposed trading limitations on foreign exchange traders.
Following a forex hedging strategy, a trader cannot profit, but having two orders open implies twice the spread, and twice the cost. Forex hedging usually leads to trading hesitancy. Traders could struggle to manage positions moving in opposite directions, producing confusion and stress.
We might utilise a forex correlation hedging strategy for this, which entails identifying two currency pairings that are directly related, such as EUR/USD and GBP/USD. If you are wanting to hedge your USD exposure, you might establish a long position for GBP/USD while shorting EUR/USD.
There are a huge range of risk management tactics that forex traders can adopt to take control of their potential loss, and hedging is among the most common. Common tactics include simple forex hedging, or more complex systems involving numerous currencies and financial derivatives, such as options.
Universal applicability:
Hedging strategy is not limited to the foreign exchange market. Beginners with knowledge of hedging can trade in assets such as stocks, cryptocurrencies, indices, commodities, and others. They can even hedge forex trade with correlated assets of different markets.
For example, you have opened a long position in the USD pair. Now, you want to hedge currency risk, so you can consider buying XAU or gold of the same size.
Risk Management:
At the beginning stage, it is possible that traders may regret opening a trade position. In such cases, they can reverse the decisions by opening opposite positions in correlated pairs. Also, during high-volume transactions, beginners can practice hedging to deal with unpredictable market changes.
Significant Profit Potential:
Most traders think of hedging as a risk management strategy. However, it can also give you significant profit if used properly. You just need to manage trade size according to the profit expectation.
Suppose you have opened a buy position in GBP/USD. Due to the market change, you think that the pair will fall. Now in this, you can open a short position in the same pair by increasing the trade size to make a profit.
Suitable for Option Beginners:
Hedging is an excellent way to trade in financial derivatives such as forex options or future contracts. These contracts allow traders to buy or sell a currency pair at a predetermined rate at a future date with some specifications. Even the derivative contract involves potential risk, and by incorporating hedging, traders can reduce the risk amount.
Volatility Management
Foreign exchange is amongst the most volatile markets. It means the forex currencies saw a significant rise and fall over a period. That’s the reason why short-term traders choose forex over others. However, high volatility means high risk and this is when hedging can save your capital. Traders can use hedging while trading highly volatile currency pairs with unpredictable market conditions.
Is hedging in forex illegal?
No, forex hedging is not illegal. It is a legitimate strategy to make money in the financial market. Even governments and central banks of different countries engage in currency hedging.
However, in countries where forex trading is illegal, you cannot practice hedging. Also, some countries have prohibited traders from using hedging. Like in the USA, traders are not allowed to use some hedging strategies.
So you need to check your country’s trading guidelines for a clear idea. For that purpose, you can visit the website of the financial institute that regulates forex trading activities in your country.
Bottom Line
Forex hedging is a strategy with dual benefits. Traders can make a profit and protect themselves from risk simultaneously. However, practicing hedging can be complex, especially for beginners.
Improper execution can increase your losses instead of profit. Also, hedging causes a significant cost, so over-hedging may result in a negative outcome.
No strategy is perfect; the same is true for hedging. Hedging may have some limitations, but little knowledge can help you in fighting with these limitations.
Thus before integrating hedging into your trading journey first get in-depth knowledge. You can also refer to our educational resources to master the art of hedging in forex.