Forex Hedging Strategies

forex hedging strategies

The forex market is growing its wings for several decades without a halt and forex trading has become a common phenomenon with countless returns. The requirement of trades, employments and services channelise currency trading. Foreign currencies are used as barter for getting goods and materials. International trade organisations depend on them. The price of raw materials is set as per the value of currencies. Hence, there is plenty of movement in the market. Forex heading is one of the methods that work as a deterrent against adverse stirring of currency values.

Forex hedging strategy helps in reducing the risk posed by extreme movements in the valuation of currencies due to several reasons. To counter that, new positions are opened in the financial market.

If a trader has the intuition or leads regarding the crash in the market or hike, hedging strategy helps in reducing or minimising it to an extent. So, when there’s any market uncertainty people resort to using hedging strategies for countering the issue. Users can use a simple forex hedging strategies to stop losing money rapidly and making gains.

For keeping the mind at equilibrium and peace, there are several forex hedging strategies for investors.

What is Forex?

Before knowing about the myriad hedging strategies applicable in the world, one should know the requirement of fiat currencies and why it is needed for trading. Forex is an amalgamation of two terms, foreign and exchange. It is related to the exchange of currencies in the global market during trades, tourism, and exchange as a money-making source. It is a method where one currency is changed with the other based on their valuation in the current market.

As per the triennial report released in April 2021, the daily average transaction of the forex market is USD 6.6 trillion. It is more than the GDP of several nations globally. So, the impact of foreign exchange trading is massive and beyond the imagination of a normal trader. If hedging is intermixed, people can make huge money in a short time.

Foreign exchange is a place where all currencies are available to traders for exchanging into the other as per the market value. Every financial stream is directly connected to forex and currencies as everyone requires money to lead life. Commerce, trade and finance make forex the most expanding and liquid market worldwide.

Interestingly, some of the biggest market participants take the help of forex and initiate hedging against international currencies. They also use it to minimise the risk of interest rates and diversifying their existing portfolios along with speculating geopolitical events that can leave an everlasting impact on financial markets.

Forex Market Offerings

Forex markets are present as derivatives markets, and as cash (spot). They offer currency swaps, options, forwards and futures. So, traders have plenty to opt from while they trade in the currency market.

Worldwide currencies from different countries get traded in the forex market and that is what it is known for. Through currencies, one can buy and sell goods and services within and across the borders of a nation. For conducting foreign trade and business, the exchange of currencies is pivotal internationally.

For example, if you live in France and want to purchase a car from the US, then you’ll have to euro equivalent to the valuation of the US dollar and then purchase the car. Moreover, taxes and other commission charges are excluded. Moreover, if a traveller from Britain is going to Switzerland on a tourist Visa would require to convert Pound Sterling into Swiss Franc or Euro because that is what is locally accepted there.

So, there are several over the counter exchanges and online exchange platforms where tourists can exchange their currencies equivalent to the other currency’s value at that moment.

Notably, there’s no central place for exchanging currencies in the forex market. One can exchange if twenty-four hours relentlessly and five days a week. So, traders have decent chances to change their currencies even during odd hours. It is because currency trading takes place in different time zones and at various places, including New York, Tokyo, Frankfurt, Hong Kong, Sydney, Paris, Singapore, Zurich and London.

One may find fluctuations in the forex market at any given point following unexpected events in the world occurring at peculiar time zones. Thus, price quotes change rapidly.

Forex Hedging Strategies

There are three most popular hedging strategies in the forex market for making big gains. All the methods are different and fulfil the requirements of every trader on the block.

Forex Hedging Strategies 1

Here, highly negative and positive currency pairs that are correlated are brought into use. For example, if an investor takes a short position on EUR/GBP and a long position on EUR/USD simultaneously it will help offset losses of one currency through gains in the other while trading. Both pairs are correlated with EUR (euro).

Forex Hedging Strategies 2

In this method, positions are opened on three currency pairs usually. So, for each currency, there is one short and one long position. For example, an investor can open a long position on USD/JPY, and GBP/USD, while a short position on GBP/JPY. It is denoted as a perfect hedging strategy or direct hedging strategy for there is one buy and one sell position.

Forex Hedging Strategies 3

In the third method, a trader does not require to open several positions, as some professional traders can make do with using options contracts. Thus, investors can buy or sell the currency pair at a given date and at a fixed price and earn profits if everything goes as per their plans.

For example, a client opens a long position on GBP/EUR at level 80. Simultaneously, the individual can buy a put option at 79. It will work like insurance as the GBP plunges against the EUR in future, the trader would be able to salvage the pride by exercising options and losses would be curtailed.

So, forex hedging strategies are fully equipped to curtail the risk ratio that might arise due to several reasons in the market. Also, the potential losses come down too. However, they are not equipped with cent per cent success.

Lets us elaborate on the strategies further and understand them deeply.

Direct Foreign Exchange Currency strategy

One of the trading strategies involves opening both buy and sell positions in a similar currency pair. However, it is not that hunky-dory as it seems. There are a few glitches. After suffering from the global economic recession, the practice was stalled or banned. Instead, the US Commodity Futures Trading Commission channelised other regulations in 2009. For instance, if any trader tries to open a short position after opening a long position on any currency pair, in that case, the broker would comply with new rules and terminate or close the first trade.

One of the thoughts or logic that CTFC gives is that losses may induce due to the process. Another reason that the strategy was changed is it essentially comes with some loss. Theoretically, the strategy can’t work until both positions cancel each other. But there are other expenses including spreads, which add to the cost of a trader.

There’s a lawful hedging strategy that works in favour of traders and is effective at the same time. Take up three random currencies that have the maximum volume. You would be able to create three currency pairs through them. Suppose they are GBP, EUR and USD. The possible combination will also be limited to three; GBP/EUR, EUR/USD and GBP/USD.

So, if someone wants to apply to hedge, two currency pairs would go into a long position (GBP/EUR, EUR/USD) and the other one in short (GBP/USD) at the same time. The strategy can be utilised with the combination of any three available best currencies.

The bottom line is the trader gets to use an acceptable and legal method that helps in hedging from any losses.

Options Hedging Strategy in Forex

Forex hedging through options offers zero currency risk to investors using retail investor accounts for entering the financial market. Traders who are averse to opening many positions for forex hedging, get a different way to manifest their needs, which is options. Through this, they get the right over the forex asset, however, they lack an obligation before deciding to sell or buy fiat currency at a specific or predetermined date.

For instance, after a keen analysis, a trader concludes that it would be mindful to go long with the currency pair CHF/USD and he opens a position at level 1.08. So, when everything goes as per the plan and Swiss Franc appreciates against the US dollar, the investor is in the position to earn good return.

On the other side, if the trader feels that losses may occur in the future, he can buy a put option at 1.07. Hence, if Swiss Franc plunges following the trade deficit, weakening economy, sudden cut in rates or due to some unforeseen event, the trader can use the options trade and put the end to losses, limiting them at 1.07 level.

However, a trader is liable to pay premium for seeking services of options. Interestingly, several investors find this hedging strategy cheapest and the most effective compared to other forex hedging strategies. It bolsters the investment strategy for beginners and retail investor accounts lose no funds in the process.

That’s why options is one of the best forex hedging strategies. So, talking about the illustration. If CHF surges against the USD and the trader is accurate with the speculation, the winning is guaranteed in that situation. Thus, it won’t be offset by the second trade.

Meanwhile, if the market turns the flipside, the premium required to buy the option would be quite lesser compared to the loss that may occur. So, the trader or investor is in the winning situation at both ends in currency markets. It will hedge currency risk. The huge potential losses get curbed.

Forex Correlation Hedging Strategy

The forex correlation hedging strategy is one of the leading forex hedging strategies for traders that is helping them to maximise profits and hedge currency risk. It uses highly negative or positive currency pairs that have some correlation with each other. We can take an illustration of GBP/JPY and GBP/USD. Interestingly, these currency pairs may find 90 per cent or above positive correlation with each other in some cases or instances.

It would mean that the possibility of these two currency pairs moving in the same direction is 90 per cent or above. The two images below will highlight the clear picture of how the strategy works in favour of a trader.

One can check that both currency pairs, GBP/JPY and GBP/USD do not have a hundred per cent correlation. However, mostly they make a movement in a similar direction. In both cases, at the end of 2018, pound sterling plunged to some degrees. A resurgence followed it between January 2019 to April 2019. However, against the US dollar and Japanese yen, the British pound slipped sharply. It touched the bottom at the end of August 2019. Interestingly, both GBP/JPY and GBP/USD went into a recovery mode for six months and emerged to the spring highs. However, the pairs again witnessed a sharp fall in March 2020. Meanwhile, some how managed to gain some losses roughly.

The two charts above showcase the high degrees of correlation between GBP/JPY and GBP/USD. If a trader is looking for hedging strategies, for that purpose, he can open short GBP/JPY and long GBP/USD positions in the forex markets to counter market volatility.

As both the currency pairs move in a similar direction, the loss in one pair would be compensated by gain in the other substantially.

It fits well with the trading strategy. Even the negatively correlated currency pairs can be used to hedge forex. It is the best forex hedging example that can turn forex hedging profitable.

Brokers that Offset Currency Risk

Brokers play an important role in establishing direct hedge or hedging forex strategies. Brokerage firms like T1Markets, 101investing, are offering the best services and platforms to accustom forex traders. They are offering multiple forex options for trading and derivatives including trading CFDs. With their tools, indicators and advices from experts the hedging risk can be reduced significantly. 

Conclusion:

The top forex hedging strategies include the role of multiple currencies, investment objectives, investment research, traders trade, strike price, independent financial advisor, financial derivatives, hedging methods, exchange rate fluctuations, initial investment, spread betting, winning trade, trading portfolio, existing position, long trade and a FX market to say the least. Precisely, the best hedging strategy offers you the winnings among other hedging methods. So, it is important for traders to be judicious while they trade forex. CFD trading is helpful in application of these strategies.

FAQ’s

Which is the Best Forex Hedging Strategies?

Ans:- When you invest money, you should realise that a forex trader will face a hedge risk. So, if you want to choose the best strategy out of all, it has to be an option trading strategy. It comes with huge benefits in forex with a particular investment. So, when you start trading forex, begin with the same strategy.

How do you Define a Perfect Hedge in Forex?

It is a type of investment strategy that removes the possibility of risk while trading in the foreign exchange market. However, there’s a rarity in its implementation. Investor accounts lose money with a slight mistake. But one can earn net profit significantly through it.

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