Hedging in Forex: Learn How It Works and if You Should Use It

Introduction

Though not desirable, risk is an inseparable factor of the investment world. For the chance of winning to exist, you also have to deal with the risk of losing.

This is why hedging exists: it is a planned and calculated way of trying to minimize the possibility of risk, even if you don’t have a crystal ball to see the future.

Hedging is especially important for investors in the forex market, considering how volatile and fast-changing that market is by nature.

If this sounds interesting to you, keep reading to learn more about hedging, its characteristics, and if it could be useful for your portfolio strategy.

What is hedging?

A simple way to explain hedging before going in depth with the concept is to compare it to an insurance policy. We are constantly reminded of how important it is to keep insurance for a lot of things: our house, our car, and even our health. Even though it can be expensive, we pay for insurance for the simple reason that it’s still cheaper than dealing with disaster when it occurs.

Hedging is basically the same thing.

In an ideal world, your car insurance and hedging wouldn’t exist. But right here, in the very uncertain and always-changing world of reality, they could mean the difference between you losing everything, and only losing a controlled portion of it.

Hedging can be even more crucial for forex traders. In a market so complex and prone to volatility because of uncontrollable factors like politics and general world economics, hedging can provide much-desired security and more peace of mind.

How does hedging work in forex?

While hedging might not be such a common term for many investors, the mentality behind it is well-known. Whenever an investor considers diversifying their portfolio, for example, they are applying the method of hedging.

The phrase “don’t put all of your eggs in one basket” is as old as time: by spreading your resources in multiple directions, you’re more likely to reduce your losses, and you won’t be as affected if any of your investments go in a bad direction.

When it comes to forex, this applies even more strongly. Since the value of currencies is highly susceptible to geopolitics and economic news, investors may find it worthwhile to use hedging techniques to counterbalance the chances of loss.

However, one important thing to note is that hedging has its own costs, and every method will have different circumstances. Also, while a hedge can reduce losses in case things go bad, it can also reduce gains if the market surprises you with a favorable movement.

Nevertheless, some investors prefer to gain less than lose a significant amount of money in a single unlucky trade. As with many things in life, it’s a tradeoff. It’s important to consider the potential benefits on a case-by-case basis.

Types of hedging strategies

There are many hedging techniques available, both for the forex market and for other financial markets, such as stocks and commodities.

We already mentioned diversification, but another fairly common hedging method is related to futures contracts. Especially when it comes to goods like oil, sugar, corn, wheat, and so on. Take a look at this example below:

Hopefully, the example above clarified how hedging can be a double-edged sword. On one hand, if the market went down, John would be secured and would still get his planned profits for the intended period. On the other hand, he wouldn’t benefit from an unexpected rise in prices.

Another hedging strategy is simply maintaining part of your resources in cash to make sure you have some security against deeper fluctuations.

When it comes to hedging in the forex market, here are some of the main strategies:

• Perfect hedging: This is when you hold both a long and a short position of the same currency pair, meaning you’ll be compensating any loss with a respective equal gain. Note that this means your risk will be zero, but your profits may be limited.
• Correlation hedging: In this strategy, you offset your risk with a currency pair by setting up a correlated one. This correlation can be positive (if one gets a higher price, the other will follow) or negative (if one gets a higher price, the other will decrease in value).
• Options hedging: Here you can buy call and put options to make sure you will have the right, but not the obligation, to buy and sell a currency pair at a specific price at a certain moment in time. This strategy is well regarded by investors, but it has its price, as you need to pay premium costs to buy the options.
• Futures and forward contracts: As mentioned in the corn example before, it’s also possible to set contracts with fixed prices to prevent bigger losses in case of a major exchange rate variation.

Now that you’ve learned more about hedging, let’s take a look at some of its benefits and downsides.

Benefits of hedging

Interested in giving hedging a try? Take a look at some of the benefits it can offer you:

• Diversification: Lots of financial assets can be hedged, such as stocks, commodities, and currencies. By applying this concept and its specific techniques to each case, you can make sure to protect yourself from risks in multiple scenarios.
• Risk management: Investments will always come with an inherent risk, but that doesn’t mean you can’t take an active approach to minimize those risks if the situation calls for it.
• Controlled losses: Losing is a continuous possibility with investing. By using hedging, however, you can try to control those losses, getting them to a number you’re comfortable with.
• Certainty in prices: While the value of assets will always vary, it’s possible to maintain fixed prices in certain situations with strategies like futures contracts, and call and put options.

Downsides of hedging

As with any approach, hedging also has its cons. It’s important to consider these downsides before trying it:

• Costs: Hedging isn’t free. Every specific strategy will have its cost - whether that be its direct cost, such as premium payments, or the indirect cost of being on the wrong side of a hedge during a market change.
• Restricted gains: By losing your risk, you will inevitably reduce your chance of gains at the same time. It’s always a matter of deciding what you’re willing to lose in a specific situation. After all, sometimes it’s more important to guarantee fewer losses than to obtain more gains.
• Complexity: Even for experienced investors, hedging can get tricky. It will require complex market analysis, predictions of changes in economics, and even political research. All of this can get too troublesome, especially for beginners.
• Wrong opinions: Mistakes happen and your thought biases can sometimes get in the way of critical thinking. What makes it even harder is that emotional investing can happen more frequently during times of crisis, causing you to overhedge or even choose the wrong hedge option.

Practical example of hedging

Because you heard some news about the economy in Europe, you’re optimistic that the euro will get even stronger, growing to an exchange rate of 1.1500, meaning that those €10 000 would now be worth $11 500 - a profit of $500 (not considering fees for this example).

This is all good news, but what if something unexpected happens and the euro actually gets way weaker? That’s where hedging could come in handy.

By using a strategy like a put option, for example, you could protect yourself from sudden variations and make sure you would be able to sell your euros at a predetermined favorable price, even if something undesirable happens.

The table below shows both scenarios playing out with numbers:

As you can see, when things went wrong, the put option you bought was responsible for making you lose only half the amount you would have lost originally. Instead of $300, you only lost $150.

However, when things were better and the euro increased in value, the put option reduced the margin of your gains. Instead of getting $300, your profit was only $250.

This is why it’s really important to consider hedging carefully, with a case-by-case analysis, and making sure you understand the possibilities for each one.

Is hedging a good option for every investor?

While hedging can be a powerful tool for mitigating risk, it’s also a complex one that may not be suited for every investor.

If your focus is on long-term investments, for example, hedging probably won’t be much of a priority, since you don’t have the need to pay close attention to market fluctuations.

However, even if you decide hedging doesn’t make sense for your goals, it’s always useful to understand the terminology and learn more about the possibilities you have as an investor.

Summary

Hedging is an advanced method to mitigate risk and hinder potential bigger losses. While it can be extra useful for those trading in highly volatile markets like forex, it’s a strategy that comes with its own costs and risks.

As an investor it’s up to you to decide how you will manage your exposure to loss, whether through elaborate hedging strategies, or just relying on long-term safer investments.

As always, count on FBS to trade safely and to learn more about investments and finance.