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 by employing risk management techniques. There are many approaches to trading Forex out there and a viable hedging strategy is among the most powerful.
In fact, hedging is one of the best ways to minimize losses and optimize the probability of winning; that’s why many large institutions require it to be a mandatory component of their tactics, especially during major price movement periods. 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 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 2014, 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 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 big 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, 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 an interest 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 a fall in prices was not a certainty, so we went long on GBP/USD because it had a better probability of continuing up. If it did reverse, the move would be smaller than in EUR/USD.
At almost the same time, both pairs reached the peak and began to fall quickly. EUR/USD fell about 500 pips and GBP/USD fell about 300 pips. If we shorted Euro and went long on 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 shorted EUR/USD and went long on GBP/USD at the beginning of June 2014. GBP/USD made a 350 pip move to 1.7050 while EUR/USD managed 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, the long position in the GBP, was to see smaller losses, ensuring a profitable hedging strategy. That is the whole point of hedging in 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 worth only about 800 pips. This occurred while NZD/USD was 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 which 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 in the same year, NZD/USD saw a 400 pip gain. Conversely, the short in AUD/USD realized only a 200 pip gain for the same time period back then. 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.