Hedging opportunities in the forex market
While many traders might never use hedging, it is nevertheless a useful technique to learn. There are, however, a few things you should know 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 we say 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 themself 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 between the planting season and when you are ready to sell the produce. In this case hedging would involve 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 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. However, if the value of the US dollar actually strengthens, 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.
Hedging is often compared to a form of insurance because normally a trader would use leveraged derivatives to trade the hedging instrument, reducing the initial outlay. So in the forex market you could buy the protection of a hedge trade for 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 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 restrict your possibility to make 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 the chart below. If you want to go short on EUR/GBP now, 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 to exit the hedge trade. The point marked ‘stop’ in the chart 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 while going 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.
Published: 27 March 2012
You should under no circumstances consider the information and comments provided as an offer or solicitation to invest. This is not investment advice. The information provided is believed to be accurate at the date the information is produced.