Trading Forex with Hedging Strategy - Key Takeaways
- Hedging is a complex process. It works as an insurance from price fluctuations.
- Usually, traders use hedging to protect their long positions from unwanted market news. Consequently, hedging positions are mostly short-lived and serve a purpose.
- In 2009 the US Commodities and Securities Commission (CFTC) banned the practice of opening the long and short positions on the same currency pair. However, traders can still use a direct hedging Forex strategy lawfully, by opening 3 positions involving 3 currencies, each currency being involved in one buy and one sell trade.
- Forex Correlation Hedging Strategy is another popular method, which involves opening the long and short position in two positively correlated currency pairs. Alternatively, traders can open 2 long or short trades, using two negatively correlated pairs.
- Some Forex traders prefer the use of options for currency hedging strategies. It is generally considered to be a cheap way to limit potential losses. Instead of opening multiple trades, this method involves the purchase of a put or call options for a given currency pair and exercising this option if the market goes against the trader’s position.
FAQ: Forex Hedging Technique and Strategy
Which currency pairs have the highest positive or negative correlation to USD/JPY?
Firstly it might be helpful to point out that the degree of correlation between currency pairs does not remain static, as the new market data comes in, it changes on a daily basis. However, using the historical data, we can come up with some observations.
When it comes to the USD/JPY, according to the investing.com calculator, some of the most highly positively correlated pairs are GBP/JPY, EUR/JPY, NZD/JPY, and GBP/CHF. The first three cases are quite self-explanatory since all of them involve Japanese Yen, however, it might be surprising to see the Pound/Swiss Franc rate being closely connected to USD/JPY movements.
Well, one possible explanation for this could be that both the Swiss National Bank and Bank of Japan have adopted the policy of negative interest rates. In fact, the CHF has a negative yield of -0.75% and JPY -0.1%. Therefore, both of them are quite attractive funding currencies and consequently benefit from risk-off trades.
Another possible reason for this could be the fact that both Swiss Franc and Japanese Yen have very low average inflation, compared to other major currencies. This makes them more likely to appreciate in the long term, according to the Purchasing Power Parity theory.
Interestingly enough, some of the most negatively correlated securities to USD/JPY is the price of Gold. This makes sense since in most cases a strong dollar typically puts pressure on commodity prices. Another example of this would be silver, although the actual degree of negative correlation is slightly lower than in the case of Gold. People use gold for hedging purposes when inflation is high.
Why do some traders who use Forex hedging strategies still lose money on a regular basis?
Hedging is a complex process and requires attention to detail, controlling emotions and managing trades.
Another common mistake some traders make is ignoring the size of the spreads. In the case of one or two occasional trades, this might not make much difference. However, If a market participant employs FX hedging strategies on a daily basis, then those kind of expenses can quickly add up and consume a sizable portion of the potential payout. Therefore, it is essential to find a broker who has reasonable spreads.
In addition, some traders use hedging strategies the wrong way. Let's say a trader opens a trading position and hedges against the risks. Prices are not static, they fluctuate. If an inexperienced trader uses hedging, he or she might close a hedging position in negative and witness the price to reverse, forcing to close the original position in negative as well. If a hedging is badly managed, it can be disastrous for traders.
Which currency pairs have the strongest correlations with Gold and Oil prices?
As one of the world’s largest Oil-producing nations, Canada’s economy is significantly impacted by the oil price. This influence also extends to the Canadian dollar.
To illustrate this, let us take a look at this USD/CAD daily chart:
From January 2019 to January 2020 the Price of Crude Oil was mostly fluctuating within the $50 to $62 range. The Canadian dollar was mostly stable, one could even argue that USD/CAD was even in a slow downtrend, since during the period the pair fell from 1.33 to just above 1.29 at the end of this period.
The situation changed significantly, as the Oil prices started to collapse, recently even moving into negative territory and finally stabilizing within the $12 to $16 range. As we can see from the chart above, the Canadian dollar fell considerably. In fact, at one point USD/CAD has reached 1.45, a level not seen in at least 4 years. This was followed by a pullback and now the pair is trading just above 1.40 mark, however, this is still a considerably higher rate, than during the previous years.
Besides the Canadian dollar, the Russian ruble also has a significant correlation with oil prices. However, Russian government is highly participating in currency valuation, that makes it less correlated than other petro-currencies.
Are there any other important CFTC regulations for Forex trading?
The US Commodities and Futures Trade Commission has several regulations regarding Forex trading. Firstly, according to the CFTC rules, Brokers should have at least $20 million in operating capital at their disposal. The reasoning behind this regulation is that brokers should be able to maintain their client’s positions without ever going bankrupt in case of unanticipated high market volatility.
Another essential regulation only allows traders to close their positions in a given currency pair according to the order in which those trades were opened. For example, if an individual opens one long EUR/USD position at 1.1000 and another one at 1.1050, he or she must close the first one, before doing the same with the second trade.
Finally, CFTC regulations limit the maximum leverage amount to 50:1. This is meant to reduce risks from traders and protect to some degree from large losses in a short timeframe.
Does the timeframe matter in any Forex hedge strategy?
Theoretically, the hedging Forex strategies can be used with any timeframe in mind. However, for traders who are using scalping methods on a regular basis, this can be challenging. With this style of trading every second matter, consequently opening 3 positions for this hedging trading purposes might not be the most practical approach.
Forex hedging techniques can work well with day traders. However, when it comes to long term trading, the first two methods described above might not be so beneficial. The reason behind this is that traders might be charged with rollover fees for holding several positions open, so these expenses can add up and lead to serious losses.
Despite this issue, long term traders can get around by using the third method and make use of options for hedging purposes. They still will have to pay a premium to purchase those, however, it is a much cheaper alternative to paying rollover charges on a daily basis.
Is there a Forex hedging strategy with guaranteed profit?
No, hedging is not a trading strategy. Hedging is an insurance strategy. As any insurance, it helps limit losses if things go against our predictions. And they also have a cost. When trades are placed simultaneously in opposite direction, they level each other out and traders are charged with trading fees. Hedging can be beneficial for protecting from short time price fluctuations that can be caused by upcoming news announcements, however, hedging is complex, and usually novice traders avoid using such strategies. When using hedge strategy, Forex trading becomes more complex.