What is hedging strategy in forex
Hedging strategy in forex is a risk management practice synonymous with insurance and the concept of diversification because it requires opening new positions on closely related, correlated pairs (either positive or negative correlation) to reduce risk exposure and also insure a profitable trade from the impact of unwanted, unpredicted market volatility such as the volatility on economic releases, market gaps and so on. This risk management method, by and large, does not require the use of stop loss.
It is important that traders understand that although hedging reduces the risk in trading, it also diminishes potential profits.
Because of the complexity of hedging and its oftentimes low yield, it is best for traders with large portfolio sizes that can yield significant gains hence the need to employ different strategies and fund protection tactics to yield significant profits and curb risk to the nearest minimum.
REASONS TO HEDGE IN FOREX
Just like the purpose of stop-loss, hedging meaning in forex is to limit the losses and risk exposure of trading but it offers much more unique benefits.
- Hedging forex trading strategy is a universal concept that can be applied to any asset of the financial markets by any category of trader, any style of trading and any institutional or trading firm.
- The major objective of hedging is to reduce the risk exposure in trading, therefore this practice will insure open positions against bearish market periods, inflation, economic shock, economic recessions and also the impact of central banks interest rate policies on the market volatility.
- There are different hedging strategies each suitable for a range of varying account sizes, for different trading strategies, categories of traders and also to serve specific purposes.
- Irrespective of the market direction (bullish or bearish), this risk management practice can be used to profit from both directions without knowing the actual bias of the market.
- Hedging strategies can be properly implemented into a trading plan to enhance its risk management potential and maximize the yield in profit.
- Hedging is most profitable for long term swing and position trades because it saves the time of adjusting risk parameters when operating with intraday volatility.
THE DOWNSIDE OF HEDGING STRATEGIES
- In order to yield significant gains and the multiple positions that must be opened to hedge against risk, the portfolio equity must be large.
- The major aim of these practices is to reduce the risk exposure, which also reduces the profit potential.
- Hedging is unfit on lower time frames because it is time-consuming on intraday charts and it has virtually no profit potential.
- Hedging is mostly used for long term swing or position trades which usually last over a longer time horizon, hence the trader is charged for extra costs such as commissions, carry cost and spread fees.
- Professionalism is a must to apply forex hedging techniques because poor implementation of these hedging techniques will be catastrophic.
DIFFERENT APPROACHES TO HEDGING
Forex hedging techniques require that a trader understands the dynamics of price action, proper risk management, correlation and relationship between currency pairs, in essence, to aid the proper operation of trading portfolios.
- DIRECT HEDGING:
This simply means opening a buy and sell position on the same currency pair. Opposite positions opened at the same time on a currency pair will result in a net-zero profit. Proper understanding of time and price with this hedging strategy can be used to compound more profit.
Direct hedging approach to trading was banned by the CFTC (Commodity Futures Trading Commission) in 2009. While this is strictly adhered to by brokers in the United States, brokers in other parts of the world are obliged to close direct hedging positions.
Since the ban on direct hedging, there have been other legal approaches to hedging in the forex market such as multiple currency hedging strategy, correlated hedging strategy, forex options hedging strategy and many other complex methods of hedging.
- MULTIPLE CURRENCY HEDGING STRATEGY:
This means hedging against a number of currencies by using related currency pairs.
For example, a trader is long on GBP/USD and short on USD/JPY. In this instance, the trader is actually long on GBP/JPY because the risk exposure on USD is hedged hence the hedged trade is exposed to price fluctuations in GBP and JPY. In order to hedge the risk exposure to price fluctuations in GBP and JPY, the trader sells GBP/JPY thereby making 3 transactions together that form a hedge, i.e. the trader has a buy and sell position on each of the 3 currencies.
- CORRELATION HEDGING STRATEGY:
This hedging forex strategy puts to good use the weakness and strength of positively (same direction) correlated currency pairs or negatively (opposite direction) correlated currency pairs to hedge, control the overall risk exposure of forex trading and also maximize gains from the market fluctuations.
An example of positively correlated currency pairs is AUD/USD and AUD/JPY.
(i) AUD/JPY Daily Chart. (ii) AUD/USD Daily Chart 
The major price movement of AUD/JPY are seen making higher highs in the first, second and fourth quarter of the year 2021 on the other hand, its closest currency pair in similarity and price swings AUD/USD fails to make higher highs but lower lows and lower highs. This differentiates strength in AUDJPY from weakness in AUD/USD. There's also a significant difference in the strength and weakness of the major bullish rally from August low to the October high. Another significant difference is in the 4th quarter of the year 2021 where AUD/USD makes a lower low, but AUD/JPY fails to make a similar lower low. Irrespective of the trend, correlation hedging technique can be very effective for highly positively correlated currency pairs. The idea here is to buy the currency pair with an intrinsic strength at the appropriate time and price when the market is poised to be bullish because the stronger currency pair is expected to cover more distance in terms of price and pips.
And then, sell the weaker currency pair at the appropriate time and price because when the market is poised to go bearish, the weaker currency pair is expected to drop more points in terms of price and pips.
Another example of correlated forex hedging techniques is the negative correlation between Gold and USD.
Primarily, the US Dollar is expected to be bearish whenever Gold is bullish and vice versa, this negative correlation is the reason why Gold is usually a safe haven whenever there is a Dollar crash or collapse like was spot in 2020 and also Gold is used to hedge against inflation.
The impact of the Covid-19 pandemic on Gold and the US Dollar.
(iii) Gold Daily chart. (iv) US Dollar Daily chart.
A perfect application of this negative correlation hedging strategy is in the case of the Covid-19 pandemic, a major event that shook the whole financial market. The market experienced extreme volatility in the latter month of February and also in the month of March 2020. In effect, the US dollar made its 5year high in the month of March 2020 followed by a steady downtrend all through the year 2020 to the low between July and August.
The negative correlation is seen on Gold, Gold prices had an impulsive and significant rally from its March lows in 2020 to its all-time high in the month of August 2020.
DIVERSIFICATION HEDGING STRATEGY
This hedging forex trading strategy is mainly for the purpose of maximizing gains by diversifying the risk exposure to another currency pair or more that have the same directional bias (directional bias must be sure and certain). The idea is to not get stuck in profit on one currency pair (undeterred by unforeseen news, volatility and market events) while maximizing gains by having a diversified open position on another currency pair of the same directional bias.
OPTIONS HEDGING STRATEGY
This is known to be the best hedging strategy in forex specifically designed to limit the risk of a long or short opened position but unfortunately not all brokers offer this risk management feature.
How is this done?
To limit the risk of an existing position in spite of unknown or undesired volatility in the market, a long position on a currency pair is hedged by the purchase of a put option and a short position on a currency pair is hedged by the purchase of a call option.
How does this work?
For instance, if a trader is long on AUD/JPY pair but undeterred by a major economic release wants to limit the risk with a put option strategy.
The trader buys a put option contract at a Strike Price (assume 81.50) which is below the Current Price of AUD/JPY (assume 81.80) on or before a specified expiry date usually sometimes after the economic release.
If the long position is profitable as price soar higher, a premium cost has already been paid for the put option as a short term hedge but in a case where price eventually drops at the release of the major economic announcement, regardless of the extent of the price drop, the put option is executed to limit the risk to a maximum loss.
The maximum loss is calculated as
= [the price at the time of the option purchase] - [the strike price] + [the premium cost for the option purchase].
The maximum loss for the option hedge on AUD/JPY long position
= [81.80 - 81.50] + [Premium cost for the option purchase]
= [00.30] + [Premium cost for the option purchase].
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