Hedging opportunities in the forex market
While many traders might never use hedging, it is nevertheless a useful technique to learn. However, there are a few things to be aware of about this technique before you apply it in your trading activities.
In the first place, hedging is not a way to make money; in fact if you use hedging too much you might actually diminish your profits in the long run. Hedging is a way to minimise losses; note that the term used is minimise losses rather than eliminate them.
Secondly, hedging does not come without a cost. Every hedging trade has an associated cost in terms of the spread and the stop loss if the price goes in the opposite direction.
One of the most common hedging opportunities in the forex market is where an exporter wants to protect him or her self against potential negative movements of a currency. Let us say, for example, that you are a farmer exporting vegetables to the US market. You might be concerned that the value of the US dollar might decline during the period between the planting season and the time that you are ready to sell the produce. In this case hedging would imply going short on the US dollar and long on your local currency for an amount equal to the estimated value of your harvest.
If the US dollar should be in decline during the period in question, you will lose money on the produce you sell, but will make a similar amount on the hedging investment.
The cost comes in if the value of the US dollar should actually strengthen. In this case you will make additional money on the value of your exports, but lose a similar amount on your hedging investment – unless you close it before it reaches that stage.
Why hedging is often compared to a form of insurance is because normally a trader would use derivatives instead of the full priced trading instrument. In the forex market that means you can buy the protection of a hedge trade at a cost of 1% of the amount you want to insure, if you use a forex investment leveraged at 100 to 1.
If you are invested in the EUR/USD, you could of course go short for the same amount on the same currency pair. While that might protect you against any possible losses, it will also mean that you cannot make any profit. An alternative approach is to go short on a related currency pair, such as the GBP/USD. If the one goes against you, you will most likely make money on the other currency pair.
When to close a hedge trade
Knowing when to close a hedge trade is as important, if not more important, than knowing when to start one. If the main trade actually goes in your favour, there comes a time when you should let go of the hedge. Failure to do that would, of course, mean that you forfeit any possibility of making a profit on the main trade.
In a sense, the problem is very similar to dealing with a stop loss; in an attempt to protect yourself against losses, you could actually end up wiping out your profits.
A rule of thumb
A general rule that might come in very useful is illustrated in fig. 3.27(a). If you want to go short on the EUR/GBP at the present moment, because you believe the price will turn around and head south, but you want to protect yourself against possible losses, then enter into a simultaneous long trade on a similar currency pair. If the trade goes against you, you have nothing to fear, because the hedge will protect you.
If the trade goes the way you hope, however, you have to decide when two exit the hedge trade. The point marked ‘stop’ in Fig. 3.27(a) is a sensible moment to exit. This is where the EUR/GBP price has just emerged from the Ichimoku cloud. Wait for a clear break below the cloud and then close your hedge trade.
While this is strictly speaking not what we traditionally mean by hedging, some traders believe it is possible to make money by going long overnight on a specific currency pair with one broker who does charge and pay interest on overnight positions and then go short on the same currency pair with a broker who does not pay or charge interest. While the net profit/loss on the trades will be zero, the trader will make a profit equal to the overnight interest he or she receives.