3 Highly Important Forex Hedging Strategies and Techniques

17 July 2020

Forex hedging is a method which involves opening new positions in the market in order to reduce risk exposure to currency movements.

There are essentially 3 popular hedging strategies for Forex. Nowadays, the first method usually involves the opening positions on 3 currency pairs, taking one long and one short position for each currency. For example, a trader can open a long GBP/USD, USD/JPY, and short GBP/JPY position. Since a trader has one buy and one sell position for each currency, it is called a direct or perfect hedging strategy.

Another simple Forex hedging strategy requires the use of highly positively or negatively correlated currency pairs. An example of this would be the opening of long EUR/USD and short EUR/JPY positions simultaneously. Since those two pairs are highly correlated, the loss in one case can be offset by the gains made from the second trade.

There is also a third method, instead of opening several positions, some professional Forex traders might prefer using options. This gives an individual a right to buy or sell a currency pair at a fixed price at a specific date in the future.

For example, a trader might decide to open a long AUD/JPY position at the 70 level. At the same time, he or she can purchase a put option at 69. This is like insurance because if the Australian dollar starts to fall against the Japanese Yen a trader can exercise an option, close trade at 69 and consequently limit his or her losses.

Finally, it might be helpful to point out that Forex hedging strategies do have the potential to lower risk exposure and even reduce potential losses, however, just like any other trading technique it can not guarantee a 100% success rate.

Hedging Strategies in Forex

In this article, we will discuss the following strategies:

Direct Forex hedging strategy
Forex correlation hedging strategy
Forex options hedging strategy

Let us go through each of those methods to understand what is hedging in Forex.

Direct FX Hedging Strategy

Clearly, one direct hedging strategy in Forex is to open both a buy and sell position in the same currency pair. However, this approach has two pitfalls. Firstly, after the great recession, in 2009 the US Commodity Futures Trading Commission issued a new regulation and banned this practice. For example, according to those new rules, if a trader has opened a long EUR/USD position and then tried to open a short position with the same pair, the broker is obligated to close the first trade.

The reasoning behind this is that CFTC believes that traders are always at a loss when using this method.

Another problem with this approach is that it effectively guarantees a small loss. In theory, those two positions should cancel each other, however, there are also spread expenses to take into account. Therefore, with this approach, the trader not only will not make money but also has a guaranteed loss.

Luckily, there is one hedging strategy to trade Forex, which is completely lawful and at the same time can be still effective. The basic idea behind this is quite simple: If we take 3 currencies and exclude the rest, there can only be 3 currency pairs. For example, if an individual wants to trade exclusively with USD, GBP, and JPY, there can only be three possible combinations: GBP/USD, USD/JPY, and GBP/JPY.

So for hedging purposes, traders can open a long GBP/USD, USD/JPY and a short GBP/JPY positions simultaneously. As we can see, in this case, a trader will hold one buy and one sell trade for each of those 3 currencies. Obviously this strategy is not limited to those pairs, an individual can use this method with any combination of three currencies. Forex 3 pair hedge strategy might be complex for many traders. Especially for novice traders and it might be best to use hedging in demo trading first before using them live. The upside to this approach is that a trader is using a completely legal method and at the same time is hedging his or her trades from potential losses.
Forex Correlation Hedging Strategy

One of the popular hedging strategies to trade Forex involves the use of highly positively or negatively correlated currency pairs. The GBP/USD and GBP/JPY is just one example of this. In fact, in some cases, the degree of the positive correlation between those pairs is above 90%. This essentially means that those two pairs move in the same direction for at least 90% of the time.

In order to get a clearer picture of this phenomenon, let us take a look at two images below. The first one is Daily GBP/JPY chart:

The second one represents a Daily GBP/USD chart:
Hedging strategy to trade Forex

As we can see from the above, the GBP/USD and GBP/JPY are not 100% perfectly correlated, however, most of the time, they move in the same direction. By the end of 2018, in both cases, Pound declined to a certain degree. This was followed by the resurgence of British currency from January 2019 until the end of April, during the same year. After this development, the Pound fell sharply against the Japanese Yen and the US dollar, reaching a bottom by August 2019. During the next 6 months, both GBP/USD and GBP/JPY recovered significantly and returned to the spring highs, until again falling drastically during March 2020. Recently, In both cases, the Pound regained roughly half of its losses.

As we can see from those two charts, GBP/USD and GBP/JPY usually have quite high degrees of correlation. Therefore, for hedging purposes, for example, traders can open long GBP/USD and short GBP/JPY positions. Due to the fact that those pairs typically move in the same direction, the loss in one trade will likely be compensated by winnings in the other one.

This hedging strategy for Forex traders is also helpful in the sense that the market participants can utilize not only positively but also negatively correlated pairs as well. One example of this would be AUD/USD and USD/CAD. In this case, a trader can open a long AUD/USD and USD/CAD positions. Because those two pairs mostly move into opposite directions, here also losses in one trade will be offset by the gains made in the second one, so it can still fulfill the role as a viable hedging strategy.

Forex Options Hedging Strategy

Trading options is one more method to hedge trading risks. What's more, it is less complex than simultaneously managing long and short positions on given currency pairs. Options are contract types that give traders the right, but not an obligation, to buy or sell currency at a predetermined rate at or before a specific date into the future. Options have expiration dates.

Let's take a look at an example, let's say a trader has conducted a thorough analysis of the AUD/NZD pair and concluded that it would be better to open a long AUD/NZD position at the 1.05 level. So far everything is quite straightforward if the Australian dollar appreciates against the New Zealand dollar, say to 1.07 level then an individual can have a winning trade and also earn some nice payouts in the process. However, in order to guard against the possible losses, a trader can purchase a put option at 1.04. If the trade goes against the option, the premium that was paid for purchasing the option is lost, however, the downside risks are limited.

How to choose the best Forex hedging strategy?

Hedging should not be viewed as a trading strategy. It's more like an insurance. As any insurance, it costs money. For options traders, the premium paid is that cost. Traders hedge their long positions from short time price fluctuations that can be caused by economic and political news. Usually, hedging positions are short-lived and depend on given situation. The best hedging strategy Forex traders can get is the one that best suits their needs. Direct hedging and hedging using correlated currency pairs can be highly complex for novice traders and result in higher losses than intended. When hedging, more trades need to be managed. There are more fees to pay. For many retail traders, it's best to avoid hedging due to its complexity.

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:
Forex hedge strategy

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.