Foreign exchange hedging is a component of risk management used by traders in global financial markets. The financial markets are volatile, and companies, financial institutions, and investors can be exposed to significant exchange rate fluctuation risks when conducting international transactions or performing investments on forex trading platforms.
There is a need to use various forms of protection when conducting these transactions, and one of these protections is known as hedging. Foreign exchange hedging involves using financial instruments and strategies to create a protective barrier against the potentially harmful or adverse effects of wild movements in foreign exchange rates. This article will attempt to explain the fundamental principles used in hedging, what instruments are used, and how to implement successful hedging strategies.
For the purpose of this discussion, we will limit the discussion of hedging around financial trading in the FX/CFD market.
Generally speaking, entities participating in foreign exchange transactions can face transactional and economic risks.
However, when it comes to the financial markets specifically, the significant risk that traders would love to hedge is the risk that comes from leverage. Leverage in FX trading is the use of borrowed capital to increase the potential return on investment. All trading in the forex markets is leveraged. Usually, in a trade, you must put down some money (margin), which functions as collateral for whatever leverage you will receive from the broker as a loan to execute all transactional sizes required in the FX markets. The leverage used determines what your margin will be.
Leverage can magnify returns, but it can also magnify the risk of capital loss. To manage the risk posed by leverage, some traders will use hedging strategies to protect against such losses rather than use stop-losses. Stop-losses will control the amount lost in a trade, but it will guarantee that the position will end in a decline in the trader's equity. On the other hand, hedging ensures that whatever risk arises from the drawdown can be managed or reduced to the barest minimum without the trader's equity suffering a debilitating decline.
No matter the trading strategies used, emotions will get involved, and this could also make the trader perform trades outside of the parameters of the strategies that have been deployed. No strategy is perfect, and there will always be situations where an adverse market movement can result in a severe decline in the trader's equity due to slippage or unattainable conditions.
Hedging is essential for protecting against unfavorable currency movements that could erode profit margins, inflate costs, or devalue investments. Companies and investors might experience significant financial distress without proper hedging strategies, especially in a volatile currency environment. For instance, a U.S.-based company that exports goods to Europe would be negatively impacted if the euro depreciates against the dollar, as it would receive fewer dollars for the same amount of euros.
One way of hedging is to trade correlated assets. There are assets whose price behavior is determined by the price behavior of assets listed under class. For instance, the price behavior of the oil companies' stocks is tied to the price behavior of crude oil in the market. When crude oil prices rise, the stocks of these oil companies rise, and when there is a dip in oil prices, the stocks of these companies move in a similar direction. In addition, some assets have inverse price relationships with other assets listed in other asset classes. So, you may have situations where a primary asset's price may rise, and a correlated secondary asset's price may fall.
It is possible to use two assets with a high degree of correlation for hedging since they are basically the same in some sense, the difference only being in their asset classification. Hedging here ensures that you can assume positions that ensure that if there are losing positions in one asset, the net gains in the other asset can cancel out these losses or contain them. You can use the differential in market times for different asset classes to get a good headstart and time your trade entries accordingly.
Example: The regional government in Eastern Libya announces that it will shut down crude oil production until further notice. At the same time, the monthly reports of the International Energy Agency (IEA) and the Organization of Petroleum Exporting Countries (OPEC) indicate that global growth demand will drop by 1 million barrels per day.
Hedge response: The response of Brent crude to these fundamentals would be a fall in prices. Assuming the trader was already long on UKOIL and the trade is now in a losing position, there is a chance of recovery by going short on the stocks of some of the oil companies listed on the trading platforms of the brokers listed on this site.
A digital option is an all-or-none option that only allows traders to profit from the asset's price direction. Unlike in the FX market, where profits depend on the direction and range of movement of the asset (the greater the number of pips, the larger the profit), digital options only require the trade to be above (Call) or below (Put) the strike price by as low as 1.0 pips.
Example: A US Federal Reserve member and policymaker, who is also a noted hawk (reluctant to keep interest rates low), suddenly notes that the US labor market is weakening and that maybe the time has come to revisit the policy of keeping the Fed Funds Rate at tight levels. Without knowing that this statement would come to public knowledge, your long position on the USDJPY starts to plummet. How can you contain the situation?
You can head over to a broker on this list that offers digital options as part of its product suite and set up a Put position on the USDJPY pair to benefit from the falling prices.
More commonly, in the FX market, the trader will open an opposite position to a current trade position to manage the loss until he finds a way to navigate out of both positions without losing money. In other words, if the trader has a buy position on the currency pair and that position is heading to negative territory, the trader will open a contrary position, that is, a sell position on the same pair, to stop the loss.
The thinking behind this hedge strategy is that, rather than use a stop-loss that will convert an unrealized loss into a realized loss, it is possible to use an opposing position to stop any further losses on the first position and subsequently use the swings of price in an attempt to manage both positions until they can be exited without the trader suffering any further losses or actually coming back from those trades with profit.
This is the standard way of using the hedging function of the MetaTrader 5 platform to manage positions using both buy and sell orders, which also allows both positions to run concurrently without further losses being incurred if the exact position sizing is used. The trader can now decide to allow the trade to swing to whichever point of support or resistance in an attempt to navigate out of each trade individually.
Any buy or sell orders with 1-1 risk-reward ratios (i.e., equidistant stop loss and take profit settings) will give you a win rate of 50% and a loss rate of 50%. Hedging aims to convert the probabilities in your favour.
Any weekly or monthly chart will show areas of rigid support and stiff resistance, usually known as the order blocks (red/resistance or green/support on this chart). Other grey areas have support and resistance levels that are not as strong as the red/green order block areas. These are the resistance and support levels on shorter-term charts.
A typical hedge of this trade using an opposing order to the existing one is an attempt to navigate out of unrealized losses. As long as there is enough capital to sustain the margin requirement and cope with the drawdown produced by the ongoing loss, the hedge is deployed in such a way as to ride the wave of the price action to an order block area, where the hedge trade can be closed in profit. The other trade can be ridden on the reversal or retracement to such a level that the combination of the outcome of both trades is either at a breakeven point or at a profit.
Example: A Canadian company that has a USD loan maturing in six months might enter into an FX swap to exchange CAD for USD now and then reverse the transaction at the loan maturity date, locking in the exchange rate and ensuring it can repay the loan without FX risk.
Here are common ways of applying hedging in FX trading.
Static hedging sets up the hedge at the beginning of the trade until you can scale out of the positions at each swing end. This is strictly a hedging method that uses fixed exposures (i.e., where the primary trade and the hedge are set up with similar lot sizes. The trader sets up buy and sell positions at the commencement of the trade and allows the trades to swing to one order block, closing off the profitable position. The trade is then allowed to reverse and swing to the opposing order block fully or partially, restoring the second trade to breakeven at the commencement point or with a loss that is smaller than the previous profit.
Example: The trader sets up a Buy and Sell order for the same asset, starting at one order block. The trade can ride to a previously established solid order block on the other end. The Buy trade is closed manually for a profit, but the sell trade remains open. The trader now lets the open trade with unrealized losses reverse from the second order block towards the initial order block, being allowed to push towards the commencement point and close at breakeven or closed off at some point along the reversal path for a realized loss that is smaller than the realized profit of the first trade.
Please note: Many brokers will not allow this in smaller time frames, so it is best practiced on order blocks in higher time frames such as the daily, weekly, or even monthly time frames.
In this example, BUY and SELL orders were set up at 1.0710. The two trades moved to 1.2500 and the BUY trade was closed at the supply order block for a profit of 1,790 pips. But now, the SELL trade is also 1,790 pips in negative territory. However, the reversal swing in price allowed for a recovery to 1.1002 where the SELL trade was closed, leaving a loss of 1.0710 - 1.1002 or 292 pips. The total profit when the position was closed was 1790 pips - 292 pips = 1498 pips
The Static Hedge assumes that the market conditions will remain constant and the order blocks will remain unbreakable. In reality, things are much more complex. Economic news will hit the newswires, and some of these macroeconomic data will cause significant shifts in market structure and sentiment bias, altering the trend and even rendering previous order blocks ineffective.
The Dynamic Hedge is used to respond to these changing market conditions and will involve the trader changing the hedge positions as long as the trade remains active. While this is a more complex approach, it is the most practicable approach.
This approach requires a solid mastery of risk management and emotional control. You must know when to ditch hedges when it all goes wrong and re-establish a new hedge to reclaim losses.
A trader named Sharise wants to perform a dynamic hedge. What steps does she follow to carry this out?
A combination of fundamental analysis and technical analysis is used. Fundamental analysis is critical because it provides a timetable of periods of potential market volatility. Technical analysis involves the identification of potential order blocks. There are technical indicators that can do this automatically.
Sharon typically initiates a trade in the direction of the trend or anticipated market movement. The static hedge will set up both buy and sell orders at once. A dynamic hedge typically starts with one trade first, which could be short or long but usually in the direction of the trend. The trades are set up in the order block zones (SELL in the supply order block, BUY in the demand order block) to give the primary trade the best chance of success without incurring a massive drawdown,
Then comes the hedge setup. After the primary trade, Sharise places a trade in the opposite position (long if the primary trade is short or short if the primary trade is long) on the same asset. Typically, the hedge is used if the market has gone contrary to the trader's primary trade position. Rather than use a stop loss that converts the unrealized losses to realized losses, the hedge is used. Usually, the hedge entry is made if the market moves against the primary trade and typically if the price action has breached the order block zone. If the market moves below the demand order block, a short position is initiated as the hedge, and vice versa.
This part requires the bulk of the trading skills and some experience to get the hang of scaling in and out of the primary trade and the hedge position.
If an order block has been breached, the natural thing to do is to follow the market with both the primary and hedge positions to the following order block in the direction of the hedge trade. In other words, if a support/demand order block is breached, follow the market until it reaches the subsequent demand order block below. Do the reverse if a supply order block is breached.
Sharise opts to close the hedge trade once the price is at the next order block. Now the hedge is in profit, but the primary trade is still in a loss position. Whether or not you close the primary trade at this point will depend on whether the market will bounce from the next demand order block or will be rejected at the next support order block.
Suppose there is a demand order block bounce or a supply order block rejection. In that case, this reversal towards the original order block where the primary trade entry was made allows the primary trade to recoup some losses. Some traders will follow the market to the original order block area and close the primary trade at breakeven or a slight loss. Typically, the safe play Sharise decides to use is to set a trailing stop to make sure the market does not reverse once more in the direction of the now-closed hedge trade. This will trigger the trailing stop and close the primary trade in a loss, but the trader would have made a profit, which is a net of the profit from the hedge trade minus the loss of the primary trade.
Some traders may decide to take a more aggressive approach. Some may use a larger volume size for the hedge trade than the original trade so that for every pip lost in the primary trade, two or more are gained in the hedge trade. The trader may then decide to end both trades at the next order block the hedge trade is chasing, ensuring a profit.
Others may decide to follow the original plan, and if there is a reversal from the second order block, another position is set up in the direction of the original trade. As the primary trade recoups losses, the new trade gains profits. This dangerous approach could quickly go south if the market turns and blows past the new order block.
Any hedge strategy requires maximum risk management, implemented at the following points.
Hedging is a method of controlling forex trading risks which aims to reduce or eliminate the chances of converting unrealized losses to realized losses by opening two or more opposing positions on the same asset. By properly utilizing the swings of price to scale in and out of all positions, the trader can aim to walk away from the positions with net profits, as opposed to using stop losses that will leave the trader with a controlled loss.
As with all strategies, it is essential to practice these with a demo account before using a live account.
