What Is Forex Hedging?
Forex hedging is a strategy used to protect against adverse moves in the forex market. Forex traders do this by opening up additional positions to reduce the risk of their trades. It is typically a form of short-term protection when a trader is concerned about news or an event triggering volatility in currency markets.
There are two related strategies when talking about hedging forex pairs in this way. One is to place a hedge by taking the opposite position in the same currency pair, and the second approach is to buy forex options.
Key Takeaways
- Hedging in the forex market is the process of protecting a position in a currency pair from the risk of losses.
- There are two main strategies for hedging in the forex market.
- Strategy one is to take a position opposite in the same currency pair—for instance, if the investor holds EUR/USD long, they short the same amount of EUR/USD.
- The second strategy involves using options, such as buying puts if the investor is holding a long position in a currency.
- Forex hedging is a type of short-term protection and, when using options, can offer only limited protection.
Strategy One
A forex trader can create a hedge to fully protect an existing position from an undesirable move in the currency pair by holding both a short and a long position simultaneously on the same currency pair.
This version of a hedging strategy is referred to as a “perfect hedge” because it eliminates all of the risk (but therefore all of the potential profit) associated with the trade while the hedge is active.
Although selling a currency pair that you hold long may sound bizarre because the two opposing positions offset each other, it is more common than you might think. Often, this kind of hedge arises when a trader is holding a long or short position as a long-term trade and, rather than liquidating it, opens a contrary trade to create the short-term hedge in front of important news or a major event.
Interestingly, forex dealers in the United States do not allow this type of hedging. Instead, firms are required to net out the two positions—by treating the contradictory trade as a “close” order. However, the result of a “netted out” trade and a hedged trade is essentially the same.
Strategy Two
A forex trader can create a hedge to partially protect an existing position from an undesirable move in the currency pair using forex options. The strategy is referred to as an “imperfect hedge” because the resulting position usually eliminates only some of the risk (and therefore only some of the potential profit) associated with the trade.
To create an imperfect hedge, a trader who is long a currency pair can buy put option contracts to reduce downside risk, while a trader who is short a currency pair can buy call option contracts to reduce the risk stemming from a move to the upside.
Imperfect Downside Risk Hedges
Put options contracts give the buyer the right, but not the obligation, to sell a currency pair at a specified price (strike price) on, or before, a specific date (expiration date) to the options seller in exchange for the payment of an upfront premium.
For instance, imagine a forex trader is long EUR/USD at 1.2575, anticipating the pair is going to move higher, but is also concerned the currency pair may move lower if an upcoming economic announcement turns out to be bearish.
The trader could hedge risk by purchasing a put option contract with a strike price somewhere below the current exchange rate, like 1.2550, and an expiration date sometime after the economic announcement.
If the announcement comes and goes, and EUR/USD doesn’t move lower, the trader can hold onto the long EUR/USD trade, potentially making additional profits the higher it goes. Bear in mind that the short-term hedge did cost the premium paid for the put option contract.
If the announcement comes and goes, and EUR/USD starts moving lower, the trader does not need to worry as much about the bearish move because it limits some of the risks.
After the long put is opened, the risk is equal to the distance between the value of the pair at the time of purchase of the options contract and the strike price of the option, or 25 pips in this instance (1.2575 – 1.2550 = 0.0025), plus the premium paid for the options contract.
Even if EUR/USD dropped to 1.2450, the maximum loss is 25 pips, plus the premium, because the put can be exercised at the 1.2550 price regardless of what the market price for the pair is at the time.
Imperfect Upside Risk Hedges
Call option contracts give the buyer the right, but not the obligation, to buy a currency pair at a strike price, or before the expiration date, in exchange for the payment of an upfront premium.
For instance, imagine a forex trader is short GBP/USD at 1.4225, anticipating the pair is going to move lower, but is also concerned the currency pair may move higher if the upcoming Parliamentary vote turns out to be bullish.
The trader could hedge a portion of the risk by buying a call option contract with a strike price somewhere above the current exchange rate, like 1.4275, and an expiration date sometime after the scheduled vote.
Not all forex brokers offer options trading on forex pairs, and these contracts are not traded on the exchanges like stock and index options contracts.
If the vote comes and goes, and the GBP/USD doesn’t move higher, the trader can hold onto the short GBP/USD trade, making profits the lower it goes. The costs for the short-term hedge equal the premium paid for the call option contract, which is lost if GBP/USD stays above the strike and the call expires.
If the vote comes and goes, and GBP/USD starts moving higher, the trader does not need to worry about the bullish move because, thanks to the call option, the risk is limited to the distance between the value of the pair when the options were bought and the strike price of the option, or 50 pips in this instance (1.4275 – 1.4225 = 0.0050), plus the premium paid for the options contract.
Even if the GBP/USD climbs to 1.4375, the maximum risk is not more than 50 pips, plus the premium, because the call can be exercised to buy the pair at the 1.4275 strike price and then cover the short GBP/USD position, regardless of what the market price for the pair is at the time.
Why Hedge FX Risk?
Hedging FX risk reduces the potential for losses due to FX market volatility created by changes in exchange rates. For companies, FX hedging is important because not only does it help prevent a reduction in profits, but it also protects cash flows and the value of assets.
Is Forex Hedging Profitable?
Forex hedging is not specifically profitable. For speculators, forex hedging can bring in profits, but for companies, forex hedging is a strategy to prevent losses. Engaging in forex hedging will cost money, so while it may reduce risk and large losses, it will also take away from profits.
Is FX Trading High Risk?
FX trading is not necessarily riskier than other types of strategies or assets. If a trade in any asset is wrong, then losses will occur. This depends on the trader and their knowledge. Traders can lose money on FX, bonds, stocks, and any other asset if they get the trade wrong.
The Bottom Line
Hedging helps mitigate risks by putting on the opposite side of the trade that the trader expects will result in a profit. So if the trader is wrong on their primary trade, then the loss would not be the absolute maximum. Hedging is a prudent measure in trading and can be applied to all asset classes.
