How Hedging Works in Forex
Eric Furstenberg • 4 min read
Most forex traders don’t understand how hedging works in forex. To many traders, hedging is some holy grail which is expected to make them tons of money in a really short time. A common perception is that a smart hedging strategy can operate with little or no risk while at the same time achieving unheard of returns. Smells fishy, doesn’t it?
Smells fishy? It’s probably too good to be true…
Many popular ‘hedging’ strategies out there are falsely called hedging strategies. While they are designed to minimise the odds of losing money and to hedge traders against market volatility, these hedging strategies actually do a good job of exposing traders’ capital to large losses. In the process, these strategies defy the boundaries of proper risk management which is an integral part of any winning strategy. In effect, these hedging strategies actually have nothing to do with real currency hedging.
Hedging – Trade Insurance or Account Destruction?
So what makes these strategies which are falsely called “hedging strategies” so dangerous? Here is a brief explanation of how these foolish strategies work in general.
What many traders call hedging, is actually a type of martingale trading system which is usually combined with a grid trading approach. Although there are different variations of this type of martingale-like hedging strategies, they all have the potential to blow forex traders’ trading accounts away. In certain market conditions, these trading strategies may yield exceptional results but the use of inconsistent lot sizing poses a great danger to trading accounts. Traders using martingale-like ‘hedging strategies’ can easily blow up their accounts when the wrong market condition eventually comes along.
Martingale-like ‘hedging’ strategies are pretty dangerous!
Contrary to this, proper hedging strategies limit traders’ exposure to risks taken in the forex and other markets and act as insurance against potential losses.
What is Martingale? And Why is it so Dangerous?
The classic martingale strategy was introduced by Paul Pierre Levy, a French mathematician and was a popular gambling strategy in the 18th century. The strategy basically doubles the bet after each loss until it strikes a winning spin (roulette) or a winning hand (blackjack).
The big problem with martingale forex trading systems is that it appears to offer traders a winning edge. However, it has been mathematically proven that the martingale approach does not improve the winning odds of a trading strategy. Martingale systems actually expose traders to massive losses because it progressively increases lot sizes in an attempt to recoup losses already sustained. The only way for a martingale approach to succeed in the long run is to apply it to a profitable trading strategy with consistent results. Even then, it would be foolish to apply martingale to that strategy because it greatly increases the trader’s risk. Traders should avoid any type of martingale trading strategies which are many times disguised as hedging strategies.
So What is Real Hedging(Related to FX)?
Forex Hedging by International Companies
Forex hedging is commonly exercised by large international firms who need to mitigate the risks associated with exchange rate fluctuations. This may be accomplished by engaging in derivative instruments like currency futures and options.
Forex Hedging by Currency Traders
Of course, retail forex traders seeking to profit from currency speculation may hedge their spot currency holdings with currency options but this may in some cases not be worth the option premium. For most forex traders it may be easier and less complicated to just control their risk by using stop loss orders and conservative position sizing.
Forex traders who engage in carry trade strategies may use currency options to hedge their carry trades. These traders may also use other highly correlated currency pairs to hedge their carry trades. For example, let’s say a long position on pair X yields an interest rate of 3% while a short position on pair Y yields -1.2%. If X and Y are highly correlated, a long position in X may be effectively hedged with a short position in Y, while at the same time earning positive carry(interest) between the two trades.
Forex and Energy Hedges
Certain currencies are highly correlated to the oil price. The most prominent example is the Canadian dollar. When the oil price rises, the Canadian dollar tends to benefit from it. Thus, a rising oil price often leads to a decline in the USD/CAD exchange rate. The USD/CAD and the oil price tend to be inversely correlated.
The oil price and the Canadian dollar often move in tandem.
However, there are times when the USD/CAD and oil are either correlated to a certain degree or not correlated at all. When this happens, traders may hedge their exposure to the USD/CAD by engaging in spot oil trades (CFDs) or positions in derivative instruments like futures and options.
For example, when the USD/CAD and oil are both moving higher, traders can open long trades on both of these instruments. In that case, if a sudden market shock sent the oil price lower, the USD/CAD would most probably move higher because of the Canadian dollar’s sensitivity to the oil price. This would result in a gain in the long USD/CAD trade which would absorb the losses on the long oil trade.
In case the oil price bounced abruptly due to supply constraints, for example, the long USD/CAD trade could incur losses while the long oil trade made a profit.
Of course, the USD/CAD and the oil price could both continue trading higher (for whatever reason), in which case both trades will be profitable.