Forex for a trader
How to hedge against forex risk

How to hedge against forex riskHedge Against Exchange Rate Risk with Currency ETFs. Investing in overseas instruments such as stocks and bonds, can generate substantial returns and provide a greater degree of portfolio diversification. But they introduce an added risk – that of exchange rates. Since foreign exchange rates can have a significant impact on portfolio returns, investors should consider hedging this risk where appropriate. To profit or protect from changes in currencies, traditionally, you would have to trade currency futures, forwards or options; open up a forex account; or purchase the currency itself. And the relative complexity of these strategies has hindered widespread adoption by the average investor. On the other hand, currency exchange-trade funds are ideal hedging instruments for retail investors who wish to mitigate exchange rate risk. These currency ETFs are a simpler, highly liquid way to benefit from changes in currencies without all the fuss of futures or forex: You simply purchase them, as you would any ETF, in your brokerage account (IRA and 401(k) accounts included). (For more, see "Hedging With ETFs: A Cost-Effective Alternative.") Foreign exchange rates refer to the price at which one currency can be exchanged for another. The exchange rate will rise or fall as the value of each currency fluctuates against another. Factors that can affect a currency's value include economic growth, government debt levels, trade levels, and oil and gold prices among other factors.

For example, slowing gross domestic product (GDP), rising government debt and a whopping trade deficit can cause a country's currency to drop against other currencies. Rising oil prices could lead to higher currency levels for countries that are net exporters of oil or have significant reserves, such as Canada. A more detailed example of a trade deficit would be if a country imports much more than it exports. You end up with too many importers dumping their countries' currencies to buy other countries' currencies to pay for all the goods they want to bring in. Then the value of the importers' country currencies drops because the supply exceeds demand. Impact of Exchange Rates on Currency Returns. To illustrate the impact of currency exchange rates on investment returns, let's go back to the first decade of the new millennium – which proved to be a very challenging one for investors. U. S. investors who chose to restrict their portfolios to large-cap U. S. stocks saw the value of their holdings decline by an average of more than one-third. Over the approximately nine-and-a-half-year period from January 2000 to May 2009, the S&P 500 Index fell by about 40%. Including dividends, the total return from the S&P 500 over this period was approximately -26% or an average of -3.2% annually. Equity markets in Canada, the largest trading partner of the U. S., fared much better during this period. Fueled by surging commodity prices and a buoyant economy, Canada's S&PTSX Composite Index rose about 23%; including dividends, the total return was 49.7%, or 4.4% annually. This means that the Canadian S&PTSX Composite index outperformed the S&P 500 by 75.7% cumulatively or about 7.5% annually.

U. S. investors who were invested in the Canadian market over this period did much better than their stay-at-home compatriots, as the Canadian dollar's 33% appreciation versus the greenback turbocharged returns for U. S. investors. In U. S. dollar terms, the S&PTSX Composite gained 63.2%, and provided total returns, including dividends, of 98.3% or 7.5% annually. That represents an outperformance versus the S&P 500 of 124.3% cumulatively or 10.7% annually. This means that $10,000 invested by a U. S. investor in the S&P 500 in January 2000 would have shrunk to $7,400 by May 2009, but $10,000 invested by a U. S. investor in the S&PTSX Composite over the same period would have almost doubled, to $19,830. When to Consider Hedging. U. S. investors who put money into overseas markets and assets during the first decade of the 21 st century reaped the benefits of a weaker U. S. dollar, which was in long-term or secular decline for much of this period. Hedging exchange risk was not advantageous in these circumstances, since these U. S. investors were holding assets in an appreciating (foreign) currency. However, a weakening currency can drag down positive returns or exacerbate negative returns in an investment portfolio. For example, Canadian investors who were invested in the S&P 500 from January 2000 to May 2009 had returns of -44.1% in Canadian dollar terms (compared with returns for -26% for the S&P 500 in U. S. dollar terms), because they were holding assets in a depreciating currency (the U. S. dollar, in this case). As another example, consider the performance of the S&PTSX Composite during the second half of 2008. The index fell 38% during this period – one of the worst performances of equity markets worldwide – amid plunging commodity prices and a global sell off in all asset classes. The Canadian dollar fell almost 20% versus the U. S. dollar over this period. A U. S. investor who was invested in the Canadian market during this period would, therefore, have had total returns (excluding dividends for the sake of simplicity) of -58% over this six-month period. In this case, an investor who wanted to be invested in Canadian equities while minimizing exchange risk could have done so using currency ETFs.

With currency ETFs, you can invest in foreign currencies just like you do in stocks or bonds. These instruments replicate the movements of the currency in the exchange market by either holding currency cash deposits in the currency being tracked or using futures contracts on the underlying currency. Either way, these methods should give a highly correlated return to the actual movements of the currency over time. These funds typically have low management fees as there is little management involved in the funds, but it is always good to keep an eye on the fees before purchasing. There are several choices of currency ETFs in the marketplace. You can purchase ETFs that track individual currencies. For example, the Swiss franc is tracked by the CurrencyShares Swiss Franc Trust (NYSE:FXF). If you think that the Swiss franc is set to rise against the U. S. dollar, you may want to purchase this ETF, while a short sell on the ETF can be placed if you think the Swiss currency is set to fall. You can also purchase ETFs that track a basket of different currencies. For example, the PowerShares DB U. S. Dollar Bullish (UUP) and Bearish (UDN) funds track the U. S. dollar up or down against the euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc.

If you think the U. S. dollar is going to fall broadly, you can buy the PowerShares DB U. S. Dollar Bearish ETF. There are even more active currency strategies used in currency ETFs, specifically the DB G10 Currency Harvest Fund (DBV), which tracks the Deutsche Bank G10 Currency Future Harvest Index. This index takes advantage of yield spreads by purchasing futures contracts in the highest yielding currencies in the G10 and selling futures in the three G10 currencies with the lowest yields. In general, much like other ETFs, when you sell an ETF, if the foreign currency has appreciated against the dollar, you will earn a profit. On the other hand, if the ETF's currency or underlying index has gone down relative to the dollar, you'll end up with a loss. Currency ETFs can be an efficient tool that allow you to diversify away from the U. S. dollar and track the price movements for most major currencies, including the following: Hedging Using Currency ETFs. Consider a U. S. investor who invested $10,000 in Canadian stocks through the iShares MSCI Canada Index Fund (EWC). This ETF seeks to provide investment results that correspond to the price and yield performance of the Canadian equity market, as measured by the MSCI Canada index. The ETF shares were priced at $33.16 at the end of June 2008, so an investor with $10,000 to invest would have acquired 301.5 shares (excluding brokerage fees and commissions). If this investor wanted to hedge exchange risk, he or she would also have sold short shares of the CurrencyShares Canadian Dollar Trust (FXC). This ETF reflects the price in U. S. dollars of the Canadian dollar. In other words, if the Canadian dollar strengthens versus the U. S. dollar, the FXC shares rise, and if the Canadian dollar weakens, the FXC shares fall. (For more, see "Introduction to Short Selling.") Recall that if this investor had the view that the Canadian dollar would appreciate, he or she would either refrain from hedging the exchange risk, or "double up" on the Canadian dollar exposure by buying (or "going long") FXC shares. However, since our scenario assumed that the investor wished to hedge exchange risk, the appropriate course of action would have been to "short sell" the FXC units. In this example, with the Canadian dollar trading close to parity with the U. S. dollar at the time, assume that the FXC units were sold short at $100. Therefore, to hedge the $10,000 position in the EWC units, the investor would short sell 100 FXC shares, with a view to buying them back at a cheaper price later if the FXC shares fell. At the end of 2008, the EWC shares had fallen to $17.43, a decline of 47.4% from the purchase price.

Part of this decline in the share price could be attributed to the drop in the Canadian dollar versus the U. S. dollar over this period. The investor who had a hedge in place would have offset part of this loss through a gain in the short FXC position. The FXC shares had fallen to about $82 by the end of 2008, so the gain on the short position would have amounted to $1,800. The unhedged investor would have had a loss of $4,743 on the initial $10,000 investment in the EWC shares. The hedged investor, on the other hand, would have had an overall loss of $2,943 on the portfolio. Some investors may believe that it is not worthwhile to invest a dollar in a currency ETF to hedge each dollar of an overseas investment. However, since currency ETFs are margin-eligible, this hurdle can be overcome by using margin accounts (brokerage accounts in which the brokerage lends the client part of the funds for an investment) for both the overseas investment and currency ETF. An investor with a fixed amount to invest who also wishes to hedge exchange risk can make the investment with 50% margin and use the balance of 50% for a position in the currency ETF. Note that making investments on margin amounts to using leverage, and investors should ensure that they are familiar with the risks involved in using leveraged investment strategies. (For more, see "Leverage's 'Double-Edged Sword' Need Not Cut Deep.") Currency moves are unpredictable and currency gyrations can have an adverse effect on portfolio returns. As an example, the U. S. dollar unexpectedly strengthened against most major currencies during the first quarter of 2009, amid the worst credit crisis in decades. These currency moves amplified negative returns on overseas assets for U. S. investors during this period. Hedging exchange risk is a strategy that should be considered during periods of unusual currency volatility.

Because of their investor-friendly features, currency ETFs are ideal hedging instruments for retail investors to manage exchange risk. (For more, see also "Currency ETFs Simplify Forex Trades.") What is hedging as it relates to forex trading? Hedging is a strategy to protect one's position from an adverse move in a currency pair. Forex traders can be referring to one of two related strategies when they engage in hedging. A forex trader can create a “hedge” to fully protect an existing position from an undesirable move in the currency pair by holding both a short and a long position simultaneously on the same currency pair. This version of a hedging strategy is referred to as a “perfect hedge” because it eliminates all of the risk (and therefore all of the potential profit) associated with the trade while the hedge is active. Although this trade setup may sound bizarre because the two opposing positions simply offset each other, it is more common than you might think. Oftentimes this kind of “hedge” arises when a trader is holding a long, or short, position as a long-term trade and incidentally opens a contrary short-term trade to take advantage of a brief market imbalance.

Interestingly, forex dealers in the United States do not allow this type of hedging. Instead, they are required to net out the two positions – by treating the contradictory trade as a “close” order. However, the result of a “netted out” trade and a hedged trade is the same. A forex trader can create a “hedge” to partially protect an existing position from an undesirable move in the currency pair using Forex options. Using forex options to protect a long, or short, position is referred to as an “imperfect hedge” because the strategy only eliminates some of the risk (and therefore only some of the potential profit) associated with the trade. To create an imperfect hedge, a trader who is long a currency pair, can buy put option contracts to reduce her downside risk, while a trader who is short a currency pair, can buy call options contracts to reduce her upside risk. Imperfect Downside Risk Hedges: Put options contracts give the buyer the right, but not the obligation, to sell a currency pair at a specified price (strike price) on, or before, a pre-determined date (expiration date) to the options seller in exchange for the payment of an upfront premium. For instance, imagine a forex trader is long the EURUSD at 1.2575, anticipating the pair is going to move higher, but is also concerned the currency pair may move lower if the upcoming economic announcement turns out to be bearish. She could hedge a portion of her risk by buying a put option contract with a strike price somewhere below the current exchange rate, like 1.2550, and an expiration date sometime after the economic announcement. If the announcement comes and goes, and the EURUSD doesn’t move lower, the trader is able to hold onto her long EURUSD trade, making greater and greater profits the higher it goes, but it did cost her the premium she paid for the put option contract. However, if the announcement comes and goes, and the EURUSD starts moving lower, the trader doesn’t have to worry as much about the bearish move because she knows she has limited her risk to the distance between the value of the pair when she bought the options contract and the strike price of the option, or 25 pips in this instance (1.2575 – 1.2550 = 0.0025), plus the premium she paid for the options contract. Even if the EURUSD dropped all the way to 1.2450, she can’t lose any more than 25 pips, plus the premium, because she can sell her long EURUSD position to the put option seller for the strike price of 1.2550, regardless of what the market price for the pair is at the time. Imperfect Upside Risk Hedges.

Call options contracts give the buyer the right, but not the obligation, to buy a currency pair at a specified price (strike price) on, or before, a pre-determined date (expiration date) from the options seller in exchange for the payment of an upfront premium. For instance, imagine a forex trader is short the GBPUSD at 1.4225, anticipating the pair is going to move lower, but is also concerned the currency pair may move higher if the upcoming Parliamentary vote turns out to be bullish. She could hedge a portion of her risk by buying a call option contract with a strike price somewhere above the current exchange rate, like 1.4275, and an expiration date sometime after the scheduled vote. If the vote comes and goes, and the GBPUSD doesn’t move higher, the trader is able to hold onto her short GBPUSD trade, making greater and greater profits the lower it goes, and all it cost her was the premium she paid for the call option contract. However, if the vote comes and goes, and the GBPUSD starts moving higher, the trader doesn’t have to worry about the bullish move because she knows she has limited her risk to the distance between the value of the pair when she bought the options contract and the strike price of the option, or 50 pips in this instance (1.4275 – 1.4225 = 0.0050), plus the premium she paid for the options contract. Even if the GBPUSD climbed all the way to 1.4375, she can’t lose any more than 50 pips, plus the premium, because she can buy the pair to cover her short GBPUSD position from the call option seller at the strike price of 1.4275, regardless of what the market price for the pair is at the time. Using Hedging in Options Trading. Hedging is a technique that is frequently used by many investors, not just options traders. The basic principle of the technique is that it is used to reduce or eliminate the risk of holding one particular investment position by taking another position. The versatility of options contracts make them particularly useful when it comes to hedging, and they are commonly used for this purpose. Stock traders will often use options to hedge against a fall in price of a specific stock, or portfolio of stocks, that they own. Options traders can hedge existing positions, by taking up an opposing position.

On this page we look in more detail at how hedging can be used in options trading and just how valuable the technique is. What is Hedging? Why do Investors Use Hedging? How to Hedge Using Options Summary. One of the simplest ways to explain this technique is to compare it to insurance; in fact insurance is technically a form of hedging. If you take insurance out on something that you own: such as a car, house, or household contents, then you are basically protecting yourself against the risk of loss or damage to your possessions. You incur the cost of the insurance premium so that you will receive some form of compensation if your possessions are lost, stolen, or damaged, thus limiting your exposure to risk. Hedging in investment terms is essentially very similar, although it's somewhat more complicated that simply paying an insurance premium. The concept is in order to offset any potential losses you might experience on one investment, you would make another investment specifically to protect you. For it to work, the two related investments must have negative correlations; that's to say that when one investment falls in value the other should increase in value. For example, gold is widely considered a good investment to hedge against stocks and currencies. When the stock market as a whole isn't performing well, or currencies are falling in value, investors often turn to gold, because it's usually expected to increase in price under such circumstances. Because of this, gold is commonly used as a way for investors to hedge against stock portfolios or currency holdings. There are many other examples of how investors use hedging, but this should highlight the main principle: offsetting risk. Why Do Investors Use Hedging?

This isn't really an investment technique that's used to make money, but it's used to reduce or eliminate potential losses. There are a number of reasons why investors choose to hedge, but it's primarily for the purposes of managing risk. For example, an investor may own a particularly large amount of stock in a specific company that they believe is likely to go up in value or pay good dividends, but they may be a little uncomfortable about their exposure to risk. In order to still benefit from any potential dividend or stock price increase, they could hold on to the stock and use hedging to protect themselves in case the stock does fall in value. Investors can also use the technique to protect against unforeseen circumstances that could potentially have a significant impact on their holdings or to reduce the risk in a volatile investment. Of course, by making an investment specifically to protect against the potential loss of another investment you would incur some extra costs, therefore reducing the potential profits of the original investment. Investors will typically only use hedging when the cost of doing so is justified by the reduced risk. Many investors, particularly those focused on the long term, actually ignore hedging completely because of the costs involved. However, for traders that seek to make money out of short and medium term price fluctuations and have many open positions at any one time, hedging is an excellent risk management tool.

For example, you might choose to enter a particularly speculative position that has the potential for high returns, but also the potential for high losses. If you didn't want to be exposed to such a high risk, you could sacrifice some of the potential losses by hedging the position with another trade or investment. The idea is that if the original position ended up being very profitable, then you could easily cover the cost of the hedge and still have made a profit. If the original position ended up making a loss, then you would recover some or all of those losses. How to Hedge Using Options. Using options for hedging is, relatively speaking, fairly straightforward; although it can also be part of some complex trading strategies. Many investors that donЂ™t usually trade options will use them to hedge against existing investment portfolios of other financial instruments such as stock. There a number of options trading strategies that can specifically be used for this purpose, such as covered calls and protective puts. The principle of using options to hedge against an existing portfolio is really quite simple, because it basically just involves buying or writing options to protect a position.

For example, if you own stock in Company X, then buying puts based on Company X stock would be an effective hedge. Most options trading strategies involve the use of spreads, either to reduce the initial cost of taking a position, or to reduce the risk of taking a position. In practice most of these options spreads are a form of hedging in one way or another, even this wasn't its specific purpose. For active options traders, hedging isn't so much a strategy in itself, but rather a technique that can be used as part of an overall strategy or in specific strategies. You will find that most successful options traders use it to some degree, but your use of it should ultimately depend on your attitude towards risk. For most investors, a basic comprehension of hedging is perfectly adequate, and it can help any investor understand how options contracts can be used to limit the risk exposure of other financial instruments. For anyone that is actively trading options, it's likely to play a role of some kind. However, to be successful in options trading it's probably more important to understand the characteristics of the different options trading strategies and how they are used than it is to actually worry specifically about how hedging is involved. How to Hedge Your Forex Trades. With all currencies of the world fluctuating in value nonstop, there are of course going to be a huge number of different trading opportunities available to you, no matter when you decide to log into the trading platforms offered by our featured Forex Brokers. However, it is often going to be the case that a trader will prefer using their own unique trading strategy when picking out just which trades to place and the amount they are prepared to risk on each trade they do place. Risk is a very important aspect to you becoming a Forex Broker, for whilst there can be some very substantial and ongoing profits to be made in both the online and mobile Forex trading environments, you do always run the risk of making a loss. Having a deep understanding of the money markets is what allows most traders to make continuous trading profits, however when they couple their knowledge of the money markets with a very well thought out trading strategy that can also reduce the risk of making a loss. With that in mind you may be wondering if there is any way you can minimize your chance of making a loss when placing Forex trades.

There are of course lots of different forex trading strategies you may be interested in adopting, however one which does appeal to a lot of traders is something known as a Hedging Strategy. When a trader hedges their trades they are placing more than one trade on the outcome of any two currencies they have paired up together. However, it is worth noting there are only a small number of circumstances when that is going to be financially feasible. With that in mind below is a quick step by step guide which will enlighten you as to how you may be able to hedge your Forex trades, so read on to find out how this can be done. Choosing Two Currencies to Trade. One thing worth keeping in mind is that there are some currencies that are going to allow you to place a much larger range of different trades on those currencies. With that in mind if you do want to have the option of hedging any Forex trade you have placed you should be pairing up some of the major currencies as opposed to the minor currencies of the world. With that in mind make sure you are considering pairing up US Dollars, the UK Pound, and AUD and CAD along with the Euro . By doing so you will find plenty of different types of trades are offered on those pairings which will give you many additional ways to hedge your trades.

Bonuses and Hedging. Having the trading budget to be able to place additional trades once you have several trades already open and live is another factor that needs thinking about. You will never want to experience running out of trading funds when a hedging opportunity arrives. You are going to find that many different Brokers will be offering you some form of bonuses, either when you sign up as a new client of those Brokers or an ongoing bonus type offer may be made available to you. By you making use of those bonuses and promotional offers you can often massively increase the value of your trading budget, and that will obviously see you having a much higher valued trading budget and having enough funds available to allow you to hedge any open trades you currently have active. One way of you then using those bonus funds to hedge any trade is by placing an opposing trade at two different Brokers, but using the bonus funds to pay for those trades. Whilst of course when you place an opposing trade at any two different Brokers one will be a winning trade and the other will be a losing trade. However, as it will be bonus funds you are using to place and fund those opposing trades that mean you will not be using your own real money funds on those trades. As long as you utilize bonuses which only require a small volume of trades needed to be placed with those bonus credits before they become real money funds, then there is a good chance that one of those two bonuses will bear fruit and will enable you to lock in a profit overall, which is what you will of course be aiming to do when hedging your trades. Forex Hedging: How to Protect Yourself from Foreign-Currency Risks. When you do business with companies abroad and get paid in foreign currencies, you might wander if you can protect the business trade against a drop in exchange rate. Lets take an example where you do business with a South African firm that pays you in South African Rand (ZAR) for your services. You yourself are based in Europe and have to convert the South African Rand (ZAR) to the Euro (EUR) and might be worried that during the course of your working agreement with your South African partner, the value of the Rand might drop against the Euro. If you look at the EURZAR over the period October 2014 until today (January 4, 2016), then you see that the EURZAR started at 14.2068, dropped down to 12.6505 and climbed up to a value today of 16.9872.

In general you see that the base currency (EUR) is gaining in strength over time against its counter currency (ZAR). Since last summer the EURZAR has been in congestion most of the time around a price of 15.1324, but the Rand has weakened again lately against both the USD and EUR at the end of 2015. The reasons behind a weak Rand are amongst others a run of investors to risk-off markets at the end of the year, where the ZAR is considered a risk currency. Although the financial sector is the biggest contributor to the South African economy, South Africa is still a country that relies heavily on commodity exports. With commodity prices falling due to the slowdown in China, all currencies that are exposed to commodities are being sold off. Finally, South Africa is a country that is struggling to solve its own internal problems which is contributing to further Rand weakness. Although the general sentiment surrounding emerging markets is negative, South Africa is not helping its own sentiment by not solving its internal issues. Electricity shortages and a struggling manufacturing sector have to be addressed if the long-term decline of the Rand is to be turned around. The current political situation is not the best with President Zuma firing a very popular finance minister just lately and plunging the country into a further spiral down scaring off foreign investors. Read this Bloomberg article of December 2015 to get an idea of where South Africa is heading. If you expect the Rand to weaken even more while at the same time you are expected to be paid in South African Rand, you could consider several options to protect against a further decline in value.

One way to protect against a further decline in value of the Rand is to invest or shorten in an exchange-traded fund. One such an ETF is the “South African Rand WisdomTree Dreyfus ETF with the symbol SZR on the forex pair ZARUSD. Another way is to go long or short on the EURZAR or USDZAR currency pair. Lets assume that we want protection against a further weakening of the Rand against the Euro. In this example I am not considering the bid versus ask price as well as any carry trade or any interest rate differential (IRD). The current EURZAR exchange rate is 16.9820 and I am worried that the Euro might strengthen against the ZAR to an exchange rate of 22.1250. If I could borrow today 1 million Rand from my broker to convert that instantly into Euro, I would be able to buy 58.885 euro with the 1 million Rand. Then the EURZAR strengthens to 22.1250. I borrowed 1 million Rand, so have to pay that back. If I would exchange the full 58.885 euro into Rand against the new exchange rate of 22.1250, that would give me 1.347.583 rand. Deduct from that the 1 million Rand I borrowed earlier on from my broker and I have 347.583,00 rand left over which would be equal to 15.709,00 euro. So, the Rand may go down in value, but I had protected myself against it with the above currency transaction on the EURZAR. What if, however, the value of the Rand would strengthen against the Euro, then this hedge would not work and go against me. One way to limit that loss is to work with a stop-loss at 14.2129.

The EURZAR has been in congestion for the past 6 months in a price range in between 14.7172 and 15.9053 until the beginning of December where the EURZAR went to peak at 17.6175. If the EURZAR would weaken and go down, it would then be stopped out and we would loose some but limited money on the way down. On the other hand, I would then at the same time win on the business trade payment in Rand from my South African partner where now the payment in Rand would give me more Euro-money in my hand. In summary, it does pay off to think ahead. Nobody can look into the future and know for sure what a currency is going to do. Is it strengthening or weakening? You can’t tell for sure, but you can take measures to cover for currency-loss risks. Of course, one thing you can do is agree to be paid in Euro instead of Rand. If that is not an option to you, you can consider the currency hedge option. If you do consider such a strategy, be aware that there are several other ways in which you could hedge the currency risk such as a strategy using futures or forward contracts. However, you could use the spot forex market as the spreads on many currencypairs such as the EURUSD is very narrow and thus the costs low. Also, you can take advantage of leverage.

However, you also have to take the interest rate differential Carry Trade into account. Hedging Against FX Risk article 2006. Interest Rate Differential (IRD) definition. Carry Trade post on Investopedia. Hedging in the Forex Market. In the simplest terms, hedging can be described as a strategy for reducing risk and increasing winning probabilities. Hedging is a kind of insurance trick, just without an insurance fee. It simply refers to buying and selling two different assets simultaneously or within a short period. Hedging has become a common strategy in the Forex market. For example, hedging entails selecting two correlated currency pairs like the EURUSD and the EURGBP and taking opposite directions on both pairs. This tactic or strategy is usually used to avoid risk when uncertainty is high. With brokers who allow direct hedging, you are allowed to buy a currency pair and, at the same time, place a trade to sell the currency pair. This is called direct hedging. Simply, you are allowed to trade the opposite direction of your original trade without having to close that trade first. Some would rather close the original trade for a loss, and open a new position, but hedging refers to making money even if the original trade evolves against your position because the profit increases simultaneously in the second trade.

If the market should move back in favour of your first trade, you can simply close the hedging trade (second trade) or set a stop on it. The problem is that direct hedging is not supported by the majority of the brokers, and traders have to reach out for indirect methods and hedging strategies. Indirect or Complex Hedging Strategies. In order to avoid direct hedging, traders can use two currency pairs. For example, the first trade referring to USDGBP with a prediction that the USD will go up, while the second trade would include CHFUSD predicting that the USD would drop. In this case, a trader would secure and protect his position on the USD, which is positive, but at the same time, the trader is liable to fluctuations in the GBP and CHF. This type of hedging, where only one currency from a pair is protected, is not extremely reliable and profitable unless the trader has worked out a complex scheme including other currency pairs. Forex Hedging and Risk Analysis. Hedging should always be preceded by a solid market analysis. This analysis can be divided into four parts: a.) Risk analysis involves a risk assessment on the part of the trader who should evaluate if the risk can be covered by hedging or not, and if the risk is rather high or low. b.) The risk tolerance threshold is a decision that should be made by the trader. The trader decides on hisher own to what extent heshe is willing to enter a risky trade. One thing is for sure, even if hedging is a means of protection, there is no Forex trade completely free of risk. c.) Deciding on a Forex hedging strategy is the next step.

One of the most popular includes the foreign currency options technique which grants the right to the trader to buy or sell a particular currency pair at a particular exchange rate at some point in the future. d.) Close monitoring of the trade is recommended in order to observe if the strategy works and if any additional steps are needed to minimize the loss (like stop loss option, opening new positions, etc.) Five Ways To Hedge Against The Market Risks. Crispus Nyaga is a Nairobi-based trader and analyst. He started trading more than 7 years ago as a student. He has published in several reputable websites like The Street, Benzinga, and Seeking Alpha. He focuses mostly on G20 currencies, commodities like Crude oil and Gold, and European and American large-cap companies. In 2008, Warren Buffet had one of his worst year’s in the market. His portfolio declined by more than 30%. In the same year, James Simmons – who runs Renaissance Technologies – had his best year, gaining by more than 40%. In the past 20 years, the annualized returns of Buffet have been 20% while those of Simmons have been more than 40%. The two are the most successful investors in our lifetime. However, their success and accomplishments have always been covered differently. This is because while Warren loves publicity, Simmons shuns it. In fact, out of Wall Street, not many people know him. Their strategies are different. Whereas Warren Buffet buys stocks and holds them for decades, Simmons uses technology to initiate and terminate trades in what is known as high frequency trades. As such, every day, he initiates hundreds of trades. For the trades he expects to go up, he buys and sells the securities he expects to head lower. This is a good example of a hedge fund.

Using this strategy, Simmons invests during choppy markets. Please note that this article has educationaldemonstrative purpose and should not be taken as investment advice. As a trader, you can also practice the hedging methods used by Simmons. You can do this by following a strategy known as arbitrage, which is a method used to hedge against risks. The first form of arbitrage you can use is known as risk arbitrage. In this, you buy and sell securities simultaneously. These are securities that have a track record of being correlated. For example, if you expect the dollar to be strong, you can buy the dollar index. To hedge against the risk of a weak dollar, you can buy emerging market currencies like the Turkish Lira or the South African rand. Historically, when the dollar rises, emerging market currencies tend to lose and when the dollar weakens, the EM currencies tends to rise. Therefore, in this case, by buying the dollar index, you might benefit if it moves higher and lose slightly with the EM trades. If on the other hand the dollar index falls, you might benefit by gaining in the EM currencies.

Second, you can trade the merger arbitrage in what is known as an event-driven strategy. When a company announces its plan to acquire another company, the stock of the acquiring company tends to fall while the company being acquired tends to rise. Therefore, when such a deal is announced, you can initiate such a trade and benefit from the differential in the pricing. Another method of arbitrage is known as statistical arbitrage. In it, a trader takes a basket of underperforming pairs and another basket of overperforming pairs. Then, they initiate a trade where they short the overperforming pairs and buy the overperforming pairs. The hope is that these pairs will reverse. Finally, there is a type of arbitrage known as triangle arbitrage. This is a type of arbitrage that happens when there is a discrepancy in the price of foreign currencies. It is usually done when a quoted market rate does not equal to the market’s cross-exchange rate. It therefore exploits an inefficiency in the market where a currency is overvalued in one market and undervalued in another one. In it, you exchange the initial currency with the second one, the second currency for the third one, and the third one for the first.

Another way to hedge against risks is to identify the safe havens and then buy place the respective trades. For example, in an upward market where the VIX is low, you can hedge against this downward risk by buying the VIX while still holding the trending instruments. Hedging Foreign Exchange Risk. Trading on the foreign exchange markets is gaining more and more popularity. One can earn a good amount of money from forex trade. But forex trading always carries risk. Almost all the traders are looking for new ways to reduce their level of risk in forex. One of the more important methods of reducing risk in currency trading is foreign exchange hedging. Hedging in foreign exchange is a method of reducing risk where you can make larger return on your forex investment with minimum risk. Foreign exchange hedging simply is a transaction that is made by a particular forex trader to protect an established position against an unanticipated or unwanted movement in the market. Hedging foreign exchange risk helps you to reduce your level of risk and at the same time increase your ability to leverage your positions. Read the article below on forex hedging to know more about them.

The risks in the foreign exchange market can be effectively hedged in the following ways: A forward agreement is made between the holder of the currency and the buyer so as to reduce the risk of the fall in the price of the currency that you are presently holding. In this agreement, the buyer and the seller agree to trade the currency at a particular rate. This way, whereas the seller is protected from fall in the price of the currency and the buyer is protected from increase in the same. Future trading is very similar to forward agreement, where the buyer and the seller agree on a price for trading forex. The only difference being that forward is an agreement that takes place on a predefined date in future, while futures transactions are done on a different platform, known as the futures market. In option trading, the two parties decide on an agreement where, if the price of the currency decreases, the seller can sell it at the fixed price as per the agreement, which protects him from making a loss on the currency. The option is that if the price increases, you can sell it at the increased exchange rate and make profit. A very low risk form of forex hedging, in a swap contract, the seller and the buyer exchange equal starting principal amounts at the current spot rate. Exchanging fixed or floating interest rate payments, during the term, at the end of the contract period, both parties re-swap the currencies at the predetermined rate and thus end up with their original currencies. Hedging in foreign exchange can really work if you know how to implement it correctly. Going through the above article on hedging foreign exchange risk will help you to trade more confidently with minimum risks. Forex Strategy: The US Dollar Hedge. by James Stanley , Currency Strategist. Price action and Macro.

Your Forecast Is Headed to Your Inbox. But don't just read our analysis - put it to the rest. Your forecast comes with a free demo account from our provider, IG, so you can try out trading with zero risk. Your demo is preloaded with ?10,000 virtual funds , which you can use to trade over 10,000 live global markets. We'll email you login details shortly. You are subscribed to James Stanley. You can manage you subscriptions by following the link in the footer of each email you will receive. An error occurred submitting your form. Please try again later. Trading is much more than just picking a position and ‘hoping’ that the trade works out . Trading is about risk management, and looking to focus on the factors that we know . This strategy focuses on capitalizing on US Dollar volatility, and using risk management to offer potentially advantageous setups in the market.

If there is one pervasive lesson that gets taught time and time again to traders, it’s that future price movements are unpredictable. While this may sound foreign to ears hearing it for the first time, logic and common sense dictate as such. Human beings can’t tell the future; and our job as a trader is to try to forecast future price movements. This is where analysis comes in, hopefully offering traders an advantage. And further, this is where risk management plays an even more important role, just as we saw in our Traits of Successful Traders research in which The Number One Mistake Forex Traders Make was found to be sloppy risk management. In this article, we are going to look at a strategy to do exactly that. What is the USD Hedge? The USD hedge is a strategy that can be utilized in situations in which we know the US Dollar will probably see some volatility. A good example of such an environment is Non-Farm Payrolls. With The United States reporting the number of new non-farm jobs added, quick and violent moves can transpire in the US Dollar, and as traders this is something we might be able to take advantage of. Another of these conditions is the US Advance Retail Sales Report.

This is a vitally important data print that gives considerable insight into the strongest engine of the US economy; the consumer, which accounts for roughly 65% of US economic production. This number is issued on the 13 th of the month (approximately 17.5 hours from the time this article is published for the August 2013 print), and fast moves may transpire shortly thereafter. High impact USD events can be a great way to look for USD volatility. Another example is Federal Reserve meetings; with a very important meeting set to come out next week as much of the world waits to hear whether or not Fed is going to begin tapering the massive easing outlays that they’ve embarked on since the financial collapse to try to keep the global economy afloat. In all of these situations – it is absolutely impossible to predict what is going to happen. But once again, as a trader – it is not our job to predict. It’s our job to take the one strain of information that we know will probably happen and to build an approach around that. In the USD hedge, we look to find opposing currency pairs to take off-setting stances in the US Dollar. So, we find one pair to buy the US Dollar; and a different pair to sell the US Dollar. This way, we offset a portion of the risk of both trades by ‘trading around the dollar.’ A note on hedging. Hedging has a dirty connotation in the Forex market. In the Forex market, hedging is often thought of as going long and short on the same pair at the same time. This is disastrous, and an atrocity to the term ‘hedging.

’ If you buy and sell the same pair at the same time, the only way you can truly profit is from the spread compressing (getting smaller), which means that your top-end profit potential is limited. In actuality, it’s much more likely that spreads may spike during news announcements which could entail a loss on BOTH sides in this scenario. Some traders say ‘well, I’ll close out the long at a top and wait for a bottom and then close out the short.’ This just doesn’t make sense. Because if you could time your long exit that well, then why wouldn’t you just initiate the short position there after closing the long position? You still have to time the market in one of these ‘hedges.’ But extra risk is exposed from the fact that spreads can widen, and potentially trigger stops, margin calls, or any other number of bad events that simply aren’t worth it because there is so little upside of doing so. The textbook definition of hedging, and this is what is taught in business schools around the world, is that a hedge is an investment that’s intended to offset potential losses or gains that may be incurred by a companion investment. In the USD hedge strategy, that’s exactly what we’re looking to do. What Allows the USD Hedge to W ork? Quite simply, risk management; if we’re fairly certain that we’re going to see some US Dollar movement, we can use that in our approach to hypothesize that this movement may continue. By looking for a 1-to-2 risk-to-reward ratio or greater ($1 risked for every $2 sought), the trader can use this information to their advantage. Advantageous risk-reward ratios are an absolute necessity in the strategy and without them – the USD hedge will not work properly. We looked at this topic in depth in the article How to Identify Positive Risk-Reward Ratios with Price Action .

The trader looks to buy the dollar in a pair, using a 1-to-2 risk reward ratio; and then the trader looks to sell the dollar in a pair, also using a 1-to-2 risk to reward ratio. The risk and reward amounts from each setup need to be roughly equal. Risk-Reward is what allows the strategy to work properly. Created with Trading Station & Marketscope. Then, when the US dollar begins its movement, the objective is for one trade to hit its stop, and the other to move to its profit target. But because the trader is making two times the amount on the winner than they lose on the other position, they can net a profit simply by looking to utilize win-one, lose-one logic. How to Make the Strategy Most Effective. There are numerous ways to buy or sell US dollars, and theoretically traders could look to utilize the strategy on any of them. But to give ourselves the best chances of success, we can integrate some of the aforementioned analysis to try to make the strategy as optimal as possible. If I’m looking to buy the US Dollar, I want to do it against the currency that’s shown me the most weakness against the dollar of recent. And further to that point – if I’m going to sell the US Dollar I want to do it in the pairing that has shown me the most strength against the greenback. There are quite a few ways to decide how to do this. Personally, I prefer price action. We looked at quite a few ways of doing this in The Forex Traders Guide to Price Action .

Another popular, common way of doing so is by using ‘ strong-weak analysis .’ Since we have the constant of the US Dollar in all observed pairs, we can simply grade currency strength by comparing relative performance to the US Dollar. In the recent article Strong & Weak , Jeremy Wagner looked at exactly that process. -- Written by James Stanley. James is available on Twitter @JStanleyFX. To join James Stanley’s distribution list, please click here . DailyFX provides forex news and technical analysis on the trends that influence the global currency markets. How to Hedge Your Forex Trades. With all currencies of the world fluctuating in value nonstop, there are of course going to be a huge number of different trading opportunities available to you, no matter when you decide to log into the trading platforms offered by our featured Forex Brokers. However, it is often going to be the case that a trader will prefer using their own unique trading strategy when picking out just which trades to place and the amount they are prepared to risk on each trade they do place. Risk is a very important aspect to you becoming a Forex Broker, for whilst there can be some very substantial and ongoing profits to be made in both the online and mobile Forex trading environments, you do always run the risk of making a loss. Having a deep understanding of the money markets is what allows most traders to make continuous trading profits, however when they couple their knowledge of the money markets with a very well thought out trading strategy that can also reduce the risk of making a loss. With that in mind you may be wondering if there is any way you can minimize your chance of making a loss when placing Forex trades. There are of course lots of different forex trading strategies you may be interested in adopting, however one which does appeal to a lot of traders is something known as a Hedging Strategy. When a trader hedges their trades they are placing more than one trade on the outcome of any two currencies they have paired up together.

However, it is worth noting there are only a small number of circumstances when that is going to be financially feasible. With that in mind below is a quick step by step guide which will enlighten you as to how you may be able to hedge your Forex trades, so read on to find out how this can be done. Choosing Two Currencies to Trade. One thing worth keeping in mind is that there are some currencies that are going to allow you to place a much larger range of different trades on those currencies. With that in mind if you do want to have the option of hedging any Forex trade you have placed you should be pairing up some of the major currencies as opposed to the minor currencies of the world. With that in mind make sure you are considering pairing up US Dollars, the UK Pound, and AUD and CAD along with the Euro . By doing so you will find plenty of different types of trades are offered on those pairings which will give you many additional ways to hedge your trades. Bonuses and Hedging. Having the trading budget to be able to place additional trades once you have several trades already open and live is another factor that needs thinking about. You will never want to experience running out of trading funds when a hedging opportunity arrives. You are going to find that many different Brokers will be offering you some form of bonuses, either when you sign up as a new client of those Brokers or an ongoing bonus type offer may be made available to you. By you making use of those bonuses and promotional offers you can often massively increase the value of your trading budget, and that will obviously see you having a much higher valued trading budget and having enough funds available to allow you to hedge any open trades you currently have active. One way of you then using those bonus funds to hedge any trade is by placing an opposing trade at two different Brokers, but using the bonus funds to pay for those trades. Whilst of course when you place an opposing trade at any two different Brokers one will be a winning trade and the other will be a losing trade. However, as it will be bonus funds you are using to place and fund those opposing trades that mean you will not be using your own real money funds on those trades.

As long as you utilize bonuses which only require a small volume of trades needed to be placed with those bonus credits before they become real money funds, then there is a good chance that one of those two bonuses will bear fruit and will enable you to lock in a profit overall, which is what you will of course be aiming to do when hedging your trades.



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