Forex Hedging Strategies
Strategies
Forex Hedging Strategies
Forex hedging strategies are risk management approaches that minimise volatility when trading. By tactically hedging your forex currency pairs and other CFDs, you can reduce potential losses with assets that move in opposite directions.
Forex Hedging Concepts
01
Risk
Risk is a measure of the total capital you can win or lose at any given point across one or more trades.
Hedging strategies try to reduce your risk while maintaining potential profits. This usually results in short-term protection for a long-term strategy.
02
Correlation
Correlation looks at how two currencies or other financial products move in relation to one another. You measure this on a scale from -1 to +1.
-1 means the two currencies move in exactly the opposite direction.
+1 means they move in the exact same direction.
0 means they move entirely independent of one another.
03
Diversification
Diversification is the idea that spreading your money amongst many trades reduces your risk of ruin.
The risk of ruin is the chance that any particular single trade or position wipes out your account. Using a previous example, if you bet everything in the USD/JPY currency trade, you could wipe out your account.
Products Available
Currency Pairs
Traders use positively and inversely correlated currency pairs to hedge positions.
Contract for difference (CFD)
Contracts for difference are leveraged derivative products that pay you based on the difference between two underlying instruments. This can be currency pairs, interest rates, or something else.
Options Contracts
Option contracts are leveraged derivatives that you can buy or sell against various assets including currencies. Owners have the right, but not obligation, to execute the terms.
Forward Contracts (Futures):
Forward contracts and futures contracts are fairly similar. For our purposes, we’ll discuss them interchangeably. These are leveraged products with an expiration date. Unlike option contracts, the owner has an obligation to execute the contract.
Types Of Hedging Strategy
Taking an Opposite Position
Taking an opposite position involves using any financial instrument whose value moves opposite to your position. This is known as direct hedging.
Trading with Forex Options
Options contracts are derivatives financial products. These enable the holder the right to buy or sell the underlying product at a given strike price up to or at a specific date.
Hedging with Correlating Currency Pairs
Another common option for hedging is to use a correlated currency pair. There is a good article done by Tim Thomas discussing swing trading strategy.
Hedging Your Portfolio
While some traders stick with one foreign currency, many hold positions in several at once. Each of these can have a different correlation to another in the portfolio.
Mistakes
Common Hedging Mistakes
Too Complex
Hedging doesn’t need to be in place for every position. As the portfolio method shows, you can create simple hedges that cover multiple positions.
No Defined Parameters
Traders need clear reasons for their hedges. That way they know when to add them and remove them.
Misunderstanding Correlation
You need to understand the difference between normal differences and true correlation breakdowns.
Capital Management
Make sure you account for this when you take a position if you might need a hedge.