October 22, 2021

Currency risk hedging – insurance for a forex trader

5 min read
Currency risk hedging – insurance for a forex trader

Any financial activity involves some risks. Moreover, such risks exist in the work on Forex. Opening a transaction in a particular currency, you assume the risk of losses in the event of a possible unfavorable development of the situation on the rate change, which can also be called currency risks.

They are typical for foreign trade. If the currency rate falls, the exporter will suffer losses; if it rises, the importer will be in the red. As for bank deposits, deposits in precious metals and foreign currency can be considered risky.

Experienced investors have long been developing ways to minimize the possible negative effects of high-risk investments. One of the ways to prevent unexpected fluctuations of market instruments is to hedge currency risks, which have already proven their effectiveness over the years. It is realized by opening urgent transactions for insurance against unexpected rate jumps. Hedging currency risks can be considered a fairly reliable way to protect your own finances. It turns out that the price of a currency becomes fixed for you at the time of the transaction.

Hedge Definition

Let’s see what hedging is. Translated from English. The term translates as “insurance.” Accordingly, currency risk hedging is a set of actions whose purpose is to reduce the risks caused by unexpected currency fluctuations. Conducting a hedge strategy is insuring your own losses.

To understand, only one acquaintance with the definition is not enough. In this article we will look at strategies and methods for hedging Forex trading, and give examples of its types and methods.

In this case, commodity futures act as the “axiomatic” method of hedging, which allows you to buy goods in the future at a fixed price in advance. When stock indexes, options, derivatives began to appear, new possibilities for hedging appeared, and not only deals for goods. Assume that the “futures + option” formula is very common when working with a specific financial instrument – simultaneously with a futures transaction, the opposite option is opened.

Forex hedging will protect your open positions from a possible unfavorable option of changing quotes.

Forex hedging methods:

1. Intermarket hedging. Transactions on the spot market are overwhelmed with futures or options. Suppose you bought EUR / USD – it means that you need to buy an option of CALL of exactly that amount.

There is nothing complicated about this strategy. Having access to the options market, a trader can acquire contracts of the opposite direction, risking at the same time only an option contract premium. If you have correctly determined the direction of the asset, you can sell the option, losing only the premium (a small amount compared to the total amount of the transaction). If you make a mistake, then insurance will work in the form of an option, which will not allow you to lose the deposit.

Pros: 

  • really working hedge strategy (we recommend to use)

Minuses: 

  • need to understand the options market

2. Cross-hedging. It assumes the opening of the opposite transaction in a different currency pair. A pair is selected with an inverse correlation to the main instrument. Some experience is required to successfully complete a transaction, as well as double the investment.
3. Lock a deal or “lock” . Opens the opposite transaction for the same currency pair. This strategy is often used by newbies, having read something on the Internet or having heard the advice of more experienced comrades. At first glance, it looks very attractive, but be careful, there are some nuances here and if misused, you can incur significant losses. In view of the popularity of these strategies on various sites, we will tell about them in more detail in order to protect you from rash actions.

There are the following types of locks:

  1. Negative – locks, set when the trader is in the red. Example: you bought a USD / CHF currency pair at 1.03, but the price went down and at 1.025 you decide to open a second position to sell the same pair. So you make yourself a safety cushion, because having closed both positions you will lose less than if the second was not.
  2. Positive locks – the situation is similar, only the lock is placed when the trader is in the black. With this lock, you reduce your profits, but insure yourself against losses in the event of a trend reversal.
  3.  Zero lock – at the same time 2 positions are opened for the same asset, but in different directions. Then the loss-making deal closes, and with a profitable one you earn.

It should be noted that the possibility of locking in the MetaTrader terminal of the 5th version is not provided by all brokers.

Useful Hedge Tips

• If there is an unprofitable position, and even more so, if the call margin is threatened, it is better to resort to a hedge in order to minimize losses. But before that it is logical to conduct a thorough analysis of the market situation. Sometimes a simpler option is the banal closing of a position than waiting for the necessary changes.
• Hedging can be a good alternative to stop loss in cases where signals of a possible return to the original indicators are visible.
• Do not open more than 2 multidirectional transactions. If there are a lot of open orders, it is very difficult to work in such a situation.
• It is considered that the optimal way to exit their hedge is to fix the price at the extreme of the movement, after that the price changes already in the “good” direction. However, as practice shows, the real market is much more complicated, and the “peak” may actually be another course correction.
• If you are going to hedge, then select the trading tools of high quality initially. As the event develops, try to understand the logic of the movement. Usually, if the price of certain raw materials increases, the price of shares of companies using these raw materials in their production will fall. Good case for hedging, right?
• Exit from hedging is similar to exiting locking.
• When hedging a trader must prepare for an additional psychological burden.

Conclusions: should hedging be applied?

The undoubted advantage of this approach is risk reduction and savings of deposit funds. Both experienced traders and novice investors resort to hedge. Usually, if a trader trades in multiple instruments, he adds gold to them. Why? Everything is very simple: gold was valued in all times of crisis. And if other instruments suffer a “fever”, then gold can save the entire investment portfolio by improving the indicator of the overall balance line of the deposit.

For all its apparent simplicity, hedging is a complex approach. Although traders try to reduce risks in this way, hedging itself creates some risks. And without a high-quality theoretical basis or sufficient experience, it is better not to make hasty decisions. Before implementation in the real market, it is better to hone the hedging skills on a demo account .