The hedging strategies are designed to minimize the risk of adverse price movement against an open trade. If you fear a stock market crash is coming or you just want to protect one of your trades from the market uncertainty you can use one of the many types of hedging strategies to gain peace of mind.
You probably have heard that in times of distress investors are buying puts to protected profits and hedge risk in case of a selloff. That is one way on how to hedge stocks, but there are other hedging methods to protect your trades.
If you’re going to use derivative hedging strategies, you can only do it when you’re taking a top-down approach. If you’re going to take this top-down approach you’re going to avoid those situations where you’re increasing your exposure by selecting the wrong instrument to hedge your trades. Also, be sure to check our guide on the best stock trading strategies.
Through this article, we’re going to talk about a Forex hedging strategy and how to use simple many currencies in a hedging strategy.
But, let’s first start by discussing what is hedging risk and what a hedging strategy is.
See below:
What is Hedging in Finance
Basically, hedging is when you open trades to offset another trade that you have already opened. The hedging methods require using a second instrument or financial asset to implement risk hedging strategies.
In essence, by opening this trade you’re offsetting the risk. Secondly, before opening a hedge trade you need to make sure that there is some sort of negative correlation between the two opened trades.
In other words, the hedging strategies give you the chance to limit your losses without using a stop-loss strategy.
The stop-losses are a critical tool used in Forex trading to limit losses if the trade doesn’t go as planned. You simply can’t be successful in the long run if you don’t limit your downside by using stop losses.
The hedging strategies work the same way as a stop loss order in terms of limiting losses. However, the advantage of hedging is that you can also make money on the hedge trade if you carefully select the second trade.
The biggest misconception among retail traders is that the Forex hedging strategy means placing an equal and opposite trade to the one that you already have opened. In other words, if you bought 1 lot of EUR/USD, you would throw a 1 lot sell EUR/USD to offset the first trade. However, that’s not how hedging works.
Only the Forex hedging strategy requires holding buy and sell at the same time on the same pair. Forex hedging is used more to pause the profit or loss during a reversal. So, if the market is going up and you’re short, you might buy to temporarily hold the position until the market turns back in your favor.
That’s just one angle to understand what is Forex hedging.
Traders can also fall into the trap of thinking that since we are fully hedged, we can just let the trade run for weeks and months without worrying about too much. However, when you rethink that and take into consideration other factors like the carry cost, the Forex hedging strategy can suddenly lead to bigger losses.
Let’s now get into the nuts and bolts of what types of hedging strategies you can use.
Types of Hedging Strategies
If you want to use a Forex hedging strategy with a US Forex broker, it’s not possible. Hedging was banned in 2009 by CFTC. However, if you want to get around the FIFO rule you can use multiple currencies to hedge your transactions.
Now, we’re going to show you one forex hedging strategy that uses multiple currencies to hedge. You might need to read this a few times you haven’t read this before.
Just remember that when you buy a particular currency you’re always buying one currency and selling the other one. Conversely, when you’re selling you’re always selling the first currency and buying the other. So, that’s one of the checks you need to make.
Let’s say as an example of hedging strategies that you buy the USD/JPY. If you want to use hedging strategies you then have to also buy EUR/USD. In this case, you’re effectively buying EUR/JPY because the USD parts cancel each other.
Now, in order to hedge your trade, you need to sell EUR/JPY
Those three transactions together form a hedge.
Why do they form a hedge?
Because on the EUR you have both a buy and a sell, on the USD currency you also have a buy and a sell, and on the YEN you also have a buy and sell.
This is a perfect hedge and a perfect example of hedging strategies that use multiple currencies.
Note* When using these hedging strategies, the big trick is to make sure that you buy and sell transactions that cancel each other.
In the picture below you can see a number of hedging alternatives that you can play around.
Let’s now look at other types of hedging strategies.
See below:
Gold Hedging Strategies
Gold is a perfect hedge if you want to protect yourself against higher inflation. Gold prices tend to benefit when inflation runs out of control. But, Gold is also a hedge against a weaker US dollar. In other words, there is an inverse correlation between gold prices and the US dollar.
If Gold prices go up, the US dollar goes down and vice-versa.
Historically, Gold has always been perceived as a form of money, which is the reason why it’s a good hedge against a dollar collapse or against hyperinflation.
Hedging Through Options
Options hedging is another type of hedging strategy that helps protect your trading portfolio, especially the equity portfolio. You can apply this hedging strategy by selling put options and buying call options and vice-versa.
Options are also one of the cheapest ways to hedge your portfolio.
Forex Hedging Strategy Using Two Currency Pairs
There are many financial hedging strategies you can employ as a Forex trader. Understanding the price relationship between different currency pairs can help to reduce risk and refine your hedging strategies.
By using two different currency pairs that have either a positive correlation or negative relationship you can establish a hedge position.
For example, EUR/USD has an 83% negative correlation with USD/JPY. In this case, you can go long EUR/USD and short USD/JPY to hedge your USD exposure. The only drawback with these types of hedging strategies is that you’re exposed to the exchange rate fluctuations in the EUR and JPY.
In other words, if the EUR strengthens against all other currencies, then we can have a situation where the move in EUR/USD is not counteracted in USD/JPY.
See figure below:
Oil Hedging Strategies
Some currencies are more exposed to the influence of the oil price. The more noteworthy example is the Canadian dollar. Usually, there is a positive correlation between the oil price and the Canadian dollar exchange rate.
When the oil price strengthens, the USD/CAD exchange rate will weaken.
In this case, you can use the oil hedging strategy to hedge your exposure on the USD/CAD trade. You can go long USD/CAD and open a short hedging position in Oil.
Conclusion — Hedging Strategies
Retail traders hedge their trades mainly for psychological reasons and not because it’s a good trading strategy. By being able to use financial hedging strategies we get the feeling that we’re not wrong about our trades, we’re just holding for a while and then we’ll take the hedge off when things are going in the direction that we know they’re going to go.
No matter which types of hedging strategies you use, you need to understand that there are no free lunches in trading. Hedging is like buying insurance against losses!
The Forex hedging strategy is a great way to minimize your exposure to risk. It not only helps you to protect against possible losses but also it can help you to make a profit.
Thank you for reading!
