Forex (FX) hedging is a method of strategizing in a way that opens up the new positions in the market, allowing the risk of exposure to be decreased to currency movements.
There are 5 common ways you can apply a forex hedge strategy, and they’re often used to try and negate losses. So, keep reading and discover the top 5 FX hedging techniques that can help you improve your trading strategy.
- Direct FX Hedging Technique
One of the most well known FX strategies is the direct FX hedging technique. This is where you it’s open to a buy and sell position within the same currency pair. While it may be simple, it does have it’s drawbacks. For example, in 2009, a new regulation was put in place that banned this method. So, if a trader decided to open a long GBP/USD position, then tried to short position them, the broker was required to only close on the first trade. This is because it was thought that the trader would always incur a loss when this strategy was used. Another issue is the guarantee of a small loss no matter what. It’s thought that the two separate positions should cancel out any losses, but there are expenses that need to be considered.
However, there is a legal way to follow a direct FX hedging strategy and it’s quite simple. All you need to do is take three currencies and trade long with the triplet. You would then hold one buy and sell one trade for each of the currencies. As this strategy isn’t limited to just these currencies, you can use it with a combination of any that you like. The benefit of this method is that it’s completely legal and you’re hedging your trades from possible losses.
- Forex Correlation Hedging Technique
Another popular FX hedging technique is called the correlation strategy. This involves using a highly positive or a negatively correlated currency pair. Sometimes you can even see a positive correlation between the two currencies of over 90%! Although it can be pretty impossible to find a currency pair that’s 100% correlated, you can find ones that do move in a very similar way. So, to follow this technique, you would trade an open long and a short position with your two correlated currencies. Because your two pairs will generally follow the same journey, any loss in one trade will most likely be negated by a win in the other. This strategy is used by a lot of traders for this reason alone, making a brilliant way to trade for winnings.
- Forex Options Hedging Technique
The Forex Options hedging technique allows the trade the right to exchange any currency pair at the given price before a certain time and date of expiry. Options hedging is pretty popular as it helps you to lower exposure while paying less money outright. One example of this technique is where you have two currencies, GBP/EUR, and you’re open position was £0.89. Then if you’re anticipating a sharp decline and hedge the risk, you can put option at £0.88 with an expiry date of one month. After the month is up, the price may have lowered to anything below £0.88, you’ll have made a loss with the long position, but your option will be a win and help to balance the exposure. So, you can see why options hedging is extremely popular with traders!
- Simple Forex Hedging Technique
The simple forex hedging technique is as the name suggests, simple. You would open the opposing position for a current trade. So, if you had a long position on two currencies, then you could open a short one on the same ones. The net profit is always zero, your original position is now on the market for when it reverses. If you chose not to hedge the position, then your closing trade would be at a loss. However, if you do hedge, then you’ll be able to make money via the second trade. This technique is easy to do, and pretty much a guaranteed win no matter which currency pair you choose.
- Forward Contact Hedging Technique
The final FX hedging strategy we’re going to look at makes of a forward contact. This is extremely useful at helping you lower the impact of any FX risk that you may come into when trying to trade. The technique involves purchasing foreign currency at a day in the future and at a predetermined exchange rate. This strategy then locks in to today’s exchange rate and prevents you from being hit with any losses should the foreign currency value decrease. Making use of a forward contact could potentially cause a loss if the foreign currency does go up though. But with careful planning, this technique can be a brilliant way to hedge when trading, and you’re more likely to see a win than a loss.
Hedging with FX techniques has been common for years, and it’s something that a lot of traders rely upon to ensure they don’t experience too many losses. It’s not always going to work in your favour, but it can help you to lower the FX risk that comes along with trading. So, make sure you take these techniques on board and see if they can help you decrease your losses when trading. You’ll be surprised at the difference they can make!
Top 5 FX Hedging Techniques