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Hedging – Forex Trading Strategies

Traders of the financial markets, small or big, private or institutional, investing or speculative, all try to find ways to limit the risk and increase the probabilities of winning. There are many approaches to trading the Forex out there and a viable hedging strategy is among the most powerful.

In fact, hedging is one of the best ways to optimize the probability of winning and why many large institutions require it to be a mandatory component of their tactics. There are even investment funds that are named after this strategy because they ‘hedge’ most of the trades and so they are called ‘hedge funds’.

What Is A Hedging Strategy ?

To ‘hedge’ means to buy and sell two distinct instruments at the same time or within a short period. This may be accomplished in different markets, such as options and stocks, or in one such as the Forex.

In most industries, in order to limit the risk of loss, you should buy insurance. This applies to the financial markets as well, but in order to avoid the insurance fees, the hedging strategy has been developed. One of the first examples of active hedging occurred in 19th-century agricultural futures markets. They were designed to protect traders from potential losses due to pricing fluctuations of agricultural commodities.

How To Limit Risk By Hedging Forex

Hedging forex , is a very commonly used strategy. In order to actively hedge in the forex, a trader has to choose two positively correlated pairs like EUR/USD and GBP/USD or AUD/USD and NZD/USD and take opposite directions on both. Hedging is meant to eliminate the risk of loss during times of uncertainty — it does a pretty good job of that.

But safety can’t be a trader’s only concern, otherwise, it would be safest to not trade at all. That’s why we use technical and fundamental analysis to make the hedging strategy profitable, not just safe. This is where the analytical ability that will make you a profit while you take opposite positions on correlated pairs will come into play. When deciding to hedge, a trader should employ analysis to spot two correlated pairs that will not act exactly in the same way to the upside or downside movement.

Example #1: A Hedging Strategy For The GBP/USD and EUR/USD

As they say, a picture is worth 1000 words, so let’s illustrate the benefits of hedging forex with some real charts from the recent past.

Through examining the charts above, we can see that at the beginning of May both the Euro and Pound were at big round levels against the Dollar, 1.40 and 1.70 respectively. These levels were supposed to act as valid resistance.

With the EUR/USD and GBP/USD on uptrends for more than a year, a correction or reversal was late overdue. At 1.40 and 1.70, a short on both pairs seemed reasonable. However, it would be too much of a risk to enter two short positions on correlating pairs or even one if the short entry didn’t work out. To craft a proper hedging strategy , we would have to analyze which of these pairs was the weakest, short that one and enter long on the other.

Technically, the EUR/USD had made a 1,300 pip run from the bottom more than a year ago, while GBP/USD had made a 2,200 pip journey. So the Euro was not as strong as the Pound — if the dollar strengthened, the EUR/USD was positioned to fall harder. Adding to that was the data and macroeconomic outlook between the Eurozone and Britain. Europe was still struggling at the time and the data hadn’t been impressive. Conversely, the UK was on a fast expansion, with data exceeding expectations and a rate hike on the agenda of the BOE. This left us a hedging strategy based on shorting the Euro since it had the best chance to fall and potentially much further than the GBP/USD. But falling was not a certainty, so we went long the GBP/USD because it had a better probability of continuing up. If it did reverse, the move would be smaller than in the EUR/USD.

At almost the same time, both pairs reached the peak and began to fall quickly. The EUR/USD fell about 500 pips and GBP/USD fell about 300 pips. If we shorted Euro and went long Sterling with one lot each, we would have taken 5,000 USD in the first and lost 3,000 USD on the second pair. This trading plan leaves us with a 2,000 USD profit from an extremely effective hedging strategy .

The same analysis applies yet again when we short EUR/USD and go long on GBP/USD at the beginning of June. The GBP/USD makes a 350 pip move to 1.7050 while the EUR/USD manages only 150 pips. So, 200 pips with standard lots cashed in a nice 2,000 USD profit. If they both continued to fall, the short in the Euro, was positioned to fall harder. Meanwhile, long in the GBP, was to see smaller losses, ensuring a profitable hedging strategy . That is the whole point of hedging forex — smaller profits with no losers. We can, of course, bolster profits by increasing the size of trades.

Example #2: Commodity Pairs

A second example is the hedging strategy between the correlating commodity currencies AUD and NZD. On the weekly charts of these two currencies against the USD below we can see clearly that AUD/USD has been in a strong downtrend of about 2,000 pips and the retrace was only about 800 pips. This occurs while the NZD/USD is on an uptrend, with a bigger move up than the previous decline.

After the retrace on the weekly and the daily charts from 4-5 weeks previous, the uptrend was about to start its next leg up. The best option is to take a long on NZD. But to be safe, in the case of failure to continue the uptrend, a short on AUD is a more suitable play.

If the pairs were to fall, the AUD we sold is to fall harder since it’s more vulnerable to downside pressure than the NZD which we bought. The loss on the NZD was likely to be smaller than the gain on the AUD, ensuring a profit even if we were wrong about the uptrend. In the event we were correct, the NZD long was to create bigger gains than what we lost on the AUD short, guaranteeing a profit.

After entry in the beginning of June, NZD/USD has seen a 400 pip gain. Conversely, the short in the AUD/USD, has realized only a 200 pip gain. That leaves us with a 200 pip profit. When hedging forex we have to compensate the less volatile pair with a bigger size. NZD moves are about 20% smaller than AUD, so when entering the hedge the NZD trade size would be 20% bigger, therefore making the 200 pip profit a 2,400 USD profit.

Hedging-Wrapping Things Up

To summarize, hedging is not a strategy for predicting which way a certain currency pair will go, but rather a method of using the prevailing market dynamic to your advantage. A solid hedging strategy can provide an ‘insurance policy’ for trading the Forex. If you do it right, you can all but guarantee that you never lose another trade again.

In order to begin hedging forex , other trading strategies must be put into play to understand the different possibilities. Check out our ‘ Forex Trading Strategies’ page to learn more about the many Forex trading strategies that you should know.

Forex Hedge

What is a 'Forex Hedge'

A forex hedge is a transaction implemented by a forex trader or investor to protect an existing or anticipated position from an unwanted move in exchange rates. By using a forex hedge properly, a trader who is long a foreign currency pair, or expecting to be in the future via a transaction can be protected from downside risk, while the trader who is short a foreign currency pair can protect against upside risk.

It is important to remember that a hedge is not a money making strategy.

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BREAKING DOWN 'Forex Hedge'

The primary methods of hedging currency trades for the retail forex trader is through spot contracts and foreign currency options. Spot contracts are the run-of-the-mill trades made by retail forex traders. Because spot contracts have a very short-term delivery date (two days), they are not the most effective currency hedging vehicle. In fact, regular spot contracts are often why a hedge is needed.

Foreign currency options are one of the most popular methods of currency hedging. As with options on other types of securities, foreign currency options give the purchaser the right, but not the obligation, to buy or sell the currency pair at a particular exchange rate at some time in the future. Regular options strategies can be employed, such as long straddles, long strangles, and bull or bear spreads, to limit the loss potential of a given trade. (See also: Getting Started In Forex Options)

Forex Hedge Example

For example, if a U.S. company was scheduled to repatriate some profits earned in Europe it could hedge some, or part of the expected profits through an option. Because the scheduled transaction would be to sell euro and buy U.S. dollars, the company would buy a put option to sell euro. By buying the put option the company would be locking in an 'at-worst' rate for its upcoming transaction, which would be the strike price. And if the currency is above the strike price at expiry then the company would not exercise the option and do the transaction in the open market.

Not all retail forex brokers allow for hedging within their platforms. Be sure to research the broker you use before beginning to trade.

FX Hedging Strategies

We work with our clients to collaboratively identify and manage increasingly complex currency exposures. Our process is built on developing a deep understanding of the risks that your business faces, before delivering a strategy created to meet your specific objectives. Our solutions ?are designed to grow with you, and our team is dedicated to working with you every step of the way.

Market Orders

Changes in the currency markets can occur far faster than human reaction times. Using automated Market Orders, you can ensure that your business is prepared to harness opportunity or protect against downside risk when unpredictable moves occur.

Currency Options

Options allow you to protect your business against harmful currency changes, while providing the flexibility ?to capitalize on favorable movements. They can be customized to achieve budget rates, protect risk thresholds, and harness market outcomes.

Our 5-Step Hedging Process

We work with you to build a hedging strategy that best fits your market position. This is a dynamic, fluid process in which your account manager provides regular market updates and product information so that you can consistently protect your profit margins, while remaining flexible and maintaining the ability to participate in favorable market movements.

Market Orders

Our expert traders and award-winning systems can stay on top of markets for you – monitoring conditions across all active sessions so you can execute your deal to the optimal moment. All Cambridge market orders can be placed either on an overnight basis or as “good-til-cancelled,” which means that the order will remain in force until it is either executed or cancelled by you.

A target order allows you to capitalize on favorable market movements. You specify the amount of currency that you wish to exchange and a rate that is better than prevailing levels. If the market moves to your desired point, a spot, forward, or option trade is automatically executed, locking in your gains.

A stop order allows you to protect against unfavorable market movements. You specify the amount of currency that you wish to exchange and the worst-case rate that you are willing to accept. If the market moves to this risk threshold, a spot, forward, or option trade is automatically executed, ensuring that you are not exposed to further loss.

A trailing stop order allows you to protect against loss while helping you to capitalize on favorable market movements. You specify the amount of currency that you wish to exchange and the worst-case percentage change that you are willing to accept. If the market moves by more than this amount, a spot, forward, or option trade is automatically executed, ensuring that you are not exposed to further loss. If the market moves in your favor, the trailing stop moves with it, effectively harnessing gains.

You can place a target order and stop order simultaneously, by specifying that if one order is filled, the other must be automatically canceled. This eliminates the possibility of double-booking, allowing you to capitalize on favorable moves while protecting against loss.

A target order allows you to capitalize on favorable market movements. You specify the amount of currency that you wish to exchange and a rate that is better than prevailing levels. If the market moves to your desired point, a spot, forward, or option trade is automatically executed, locking in your gains.

A stop order allows you to protect against unfavorable market movements. You specify the amount of currency that you wish to exchange and the worst-case rate that you are willing to accept. If the market moves to this risk threshold, a spot, forward, or option trade is automatically executed, ensuring that you are not exposed to further loss.

A trailing stop order allows you to protect against loss while helping you to capitalize on favorable market movements. You specify the amount of currency that you wish to exchange and the worst-case percentage change that you are willing to accept. If the market moves by more than this amount, a spot, forward, or option trade is automatically executed, ensuring that you are not exposed to further loss. If the market moves in your favor, the trailing stop moves with it, effectively harnessing gains.

You can place a target order and stop order simultaneously, by specifying that if one order is filled, the other must be automatically canceled. This eliminates the possibility of double-booking, allowing you to capitalize on favorable moves while protecting against loss.

Forward Contracts

The most common hedging tool, forward contracts, fix a defined future date at which to buy or sell a stated amount of currency at an agreed rate. All forwards can be booked through our leading-edge trading platform, Cambridge Online.

Fixed Forwards

This standard forward is used for buying or selling currencies that are date-sensitive. The transaction is completed for the total amount of the contract on a specified date.

Open Forwards

You also have the option of an “open” forward, which allows the flexibility of an open time period in which to settle. Open forwards also allow you to draw down against the original amount contracted.

Hedging Strategies

We offer a robust suite of structured options designed to help you harness volatility, take advantage of market fluctuations and protect your bottom line. Certain options require no deposit or margin.

Foreign Exchange Swaps

Foreign exchange swaps are contracts wherein one currency is sold against another at inception, with a commitment to re-exchange the principal amount at the maturity of the deal in order to deploy cash resources as efficiently as possible. These swaps are structured as spot trades combined with offsetting future-dated forward contracts, so that the net foreign exchange exposure is removed and funds are positioned where needed.

Non-Deliverable Forwards

Non-deliverable forwards also fix the rate at a defined future date but delivery of the foreign currency does not occur. Instead, the difference is settled in domestic currency. Non-deliverables are used to protect against rate movements in inaccessible markets.

Vanilla Options

Vanilla options are financial contracts that give you the right, but not the obligation to buy or sell a stated amount of a currency at a predefined price over a certain period of time. Due to this functionality, they are typically used to protect uncertain future cash flows against exchange rate volatility.

Structured Options

Structured options are contracts that combine vanilla options with other special features to create a customized hedging instrument to fit a particular situation or capitalize on a potential market outcome. We can offer a variety of structured options to qualified parties. Contact a Cambridge Options Specialist to determine your needs and to view our literature on these products.

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