- What Is Hedging?
- 3 Most Essential Forex Hedging Strategies Traders Can Use
- A Guide to Managing Foreign Exchange Risk
When there are two up candlesticks with full bodies, which almost engulf the entire bear move, there is a strong risk that the EURUSD pair will go up and the uptrend will continue I highlighted the situation with the second blue oval on the right :. To reduce this risk, we enter a position, opposite the first one, of the same volume, 1 lot.
Thus, two trades will overlap each other and protect our deposit. We fix the level of a potential loss of points the spread between opening short and long positions under the conditions of strong uncertainty. Now we can safely track the market without fear of significant losses.
If the price nevertheless goes down, we will close the long position and take the profit from the short one. If there is a signal of the bull trend continuation, we shall exit the short position, and a long one will start yielding a profit. Let us study another example of full hedging forex trades. This time, we will additionally calculate the potential loss and profit resulting from exiting the hedge. In the situation, marked with the blue oval in the above chart, we decided that the price should go up soon.
So, once the bar closes, we open a long position at 1. However, the price continues going down and breaks through the support level at 1. There is quite a strong signal of the bear trend continuation.
What Is Hedging?
To protect our capital against losses, we shall apply Forex hedging. To insure against big losses, we will open the opposite position of the same volume at the level of 1. Thus, the difference between these two opposite positions is only 0. This is the amount of loss that we have limited with the help of Forex hedging. The chart above shows that the full hedging of Forex positions was appropriate.
This forex strategy allowed us to safely wait while the market was moving in an unwanted direction. The bull trend resumes after a while. When the price has consolidated sufficiently above the initial position at 1. However, the trade itself has not yet been completed, since we still have a long position, opened at 1.
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As you see from the chart, there is a strong bullish momentum next. We are following the bull trend and exit the buy position when there emerges a shooting star reversal pattern and two confirming red candlesticks down highlighted with purple in the chart. We close the position at level 1.
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Thus, the net profit yielded by the long without taking into account commissions amounted to 0. As you can see, the total profit was much reduced because of hedging. However, we are fully insured against the risk of loss that could result from a negative scenario. Well, we have already studied the example of Forex hedging. Now, let us see what ways of capital protection exist and what peculiarities they have. First, let me describe the parameters according to which the methods of hedging are classified:. There are foreign exchange and over-the-counter types of hedging instruments. Forex hedge trades are entered, as the definition implies, on the foreign exchange with the participation of a counterparty, which, in the case of Forex, is the brokerage company.
Over the counter hedge positions can not be opened on an asset exchange. They are not traded in the market and usually conducted once. There can be full or partial Forex hedging. The full one insures against risks for the whole sum of the deal. The partial one implies the insurance only of a part of the deal.
3 Most Essential Forex Hedging Strategies Traders Can Use
It is used if there are minor risks. Depending on whether you bet on the price rise or fall, you put a buyer hedge or a seller hedge.
In the first case, capital is insured against a possible increase in prices, and the second - a decrease. Forex hedging can be pure or cross. A pure hedge involves an opposite transaction for the same trading asset. In the case of cross hedging, the hedge position is opened for a different asset.
In this case, the second asset should correlate with the underlying asset, that is, its price should depend on the price of the underlying asset.
For example, when the price of the underlying asset is moving up, the value of the asset that we used for the hedge should also be moving up or down on a relative scale. In the first case, the opposite position is opened immediately after the main insured one. An example of a classical hedge is buying an option covering the main trade.
The second strategy implies putting a hedge long before the insured position is opened, as it happens in the case of buying futures. It involves opening a position of the same volume as the first one but in the opposite direction to buy or sell the same asset. Thus, you fully protect the deposit invested in the first trade from the risks of price movement in an unwanted direction.
With low potential risks of price movement in an unfavourable direction, it is possible to insure the main transaction only partially. In this case, the potential profit increases, and at the same time, the hedging costs are reduced. However, if you underestimate the risks, you may face unforeseen losses. It involves the purchase of a futures contract at a fixed price with the expectation that the asset will be sold at an optimal price in the future. This method involves opening a position on an asset different from that of the main trade. It is a rather complicated Forex hedging strategy that is recommended only for experienced traders.
It involves opening positions in the underlying asset market and the derivatives insurance market. The positions will differ both in time and size. The flexibility of the strategy allows you to choose the best proportions, achieving the optimal ratio of the potential profits to existing trading risks.
Suppose you buy 1, shares at the beginning of the year and plan to sell them at a higher price in the third quarter. In the second quarter, you put an option to sell 1, shares. At the same time, the calculations made allow you to expect with a high degree of probability to make profits from both positions closed at different times.
It involves heading the position on the assets of one sector by a position on the asset of another sector. Most of the covered Forex hedging strategies are employed by traders or funds combining different instruments or even strategies. I have covered in detail some of such systems, namely, the hedged grid forex strategies , Forex grid and Forex Double Grid Strategy, in one of my educational articles. Now is the time to summarize the above information and briefly talk about the main pros and cons of hedging.
There are a lot of advantages in employing risk-limiting strategies, that is why Forex hedging strategies are so popular. Due to a wide range of forex hedging strategies and instruments, it can be applied in any market, for any trading instrument and by traders of any level of skills. It is used by individual traders, global investment funds and it can be even an element of economic policies of a whole country. By the way, common people often use hedging as a strategy, when they, for example, invest in gold or foreign currency to insure against the risks of the local currency depreciation.
Another example, on a global scale, is the target program for the development of tourism in the United Arab Emirates, in order to diversify sources of income and reduce dependence on hydrocarbon exports. This point is a logical extension of the first one.
The flexibility of hedging results from the logical simplicity of the approach and, at the same time, the widest range of tools that make the hedging process almost universal and applicable to any transaction. Due to such a wide range of hedging tools, it is subdivided into many types:. It is a kind of mantra for any investor. Risk diversification can be considered as an example of selective and cross hedging.
The logic of this statement is quite simple and clear.
A Guide to Managing Foreign Exchange Risk
However, in the financial world, it is not so easy to follow this rule. Principles of hedging facilitate achieving the facilitation goals for an investor, defining the two major rules: it is the segmentation of assets and the correlation of asset prices in the portfolio. Segmentation means that the assets in the portfolio should belong to different markets, industries, and forms of ownership.
For example, a portfolio that includes only cryptocurrencies is less diversified than a portfolio that also includes other assets, for example, shares or bonds. I think the logic here is clear.