Hedging is one of the most essential and useful Forex operations. In the right hands, hedging allows to avoid substantial profit losses and teaches correct calculation of the factors that affect transactions and their outcome. Here we will talk about hedging in more detail.
Hedging means reducing the risk of losing profit in one trade by using the profit received from another trade.
Usually the risk of profit loss is associated with the influence market factors have on price dynamics - for example, with sharp price fluctuations or a change in the direction of the trend.
The essence of hedging is the need to create a certain balance between futures and conditions with contract obligations in the financial market.
For example:
Opening one or more buy positions in order to compensate for possible losses from a sell position or vice versa. Note that the financial instruments used for this must be identical or have a high correlation with each other.
The main goal of virtually any Forex operation is profit. But not in this case. In hedging, profit is secondary. The main purpose of hedging is to reduce potential losses.
Nevertheless, this is not the sole hedging purpose. Let’s look at the rest of the goals, as well as the most popular hedging strategies.
Hedging objectives:
Hedging strategies:
When using strategies, one must pay attention to the following factors:
Direction of movement of currency pairs. If a currency pair is unprofitable, finding another currency pair either with the same movement direction or with the completely opposite movement direction will help reduce the risk.
Speed of movement of currency pairs. When opening a deal, you need to choose the currency pair whose movement is faster. This will increase the probability of covering the loss and making a profit.
Point price. The main currency pair should have a higher pip value.
No weak currency pairs. It is pretty obvious that hedging calls for selecting strong currency pairs.
Transactions of equal volumes. Opening the second trade with a large volume is very dangerous. This carries a great risk of increasing the loss instead of receiving profit. It is preferable to open the second trade with the volume identical to the first trade.
Swap calculation. It is important to consider the possibility of a rollover after the end of the trading day.
Hedging comes in several types:
At its essence, hedging is insurance. The selling party is insured against a possible price decrease while the buying party is insured against its increase. However, there are differences between conventional insurance and hedging.
In hedging, there is a mutual offsetting of risks by both parties, for example, when one party hedges the risk of the price increase while the other, of the price decrease. As a result, if the price changes, one party will avoid losses while the other will not receive a portion of the profit. In hedging, this portion of the profit is similar to an insurance premium. When an "insured event" occurs, neither party loses anything, but they don’t gain anything either if such event does not occur.
For example, if a hedging was used to buy an underlying asset for a specified amount, that amount will be spent regardless of whether the price of the asset goes up or down.
Insurance, under similar circumstances, makes it possible to preserve this part of the potential profit. The payment for cancelling risks is a certain premium already paid at the time of signing an agreement with the insurance company.
For example, if insurance was acquired for a transaction to purchase an underlying asset, then if the price of that asset goes up, the previously agreed price and the insured amount will be spent. If the price goes down, the asset will be bought at the current price (i.e., lower than the initial one), plus the amount insured.
The financial instruments used in hedging are the following:
Futures (non-deliverable and deliverable)
Options (American and European)
Swaps (currency, commodity, stock, interest)
Forwards (deliverable, non-deliverable)
The secret to correct hedging use lies in understanding and predicting the likely losses. It is important to understand both the dynamics of prices and the direction of trends, and to be able to manage time. It is important to remember that if the perceived risks are small, the cost of hedging may exceed the benefits derived from it.