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.
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.
Objectives and strategies
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.
Reducing the risk of potential loss.
Elevating an already unprofitable position to a break-even one.
Receiving income in one or more positions.
Opening two positions with opposite directions, with the same lots for unidirectional currency pairs.
Opening two positions with the same direction and with the same lots but for oppositely directed currency pairs.
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.
Types of hedging
Hedging comes in several types:
Static - opening a new insuring position before closing the transaction with the underlying asset.
Dynamic - the insurance (hedging) position changes regularly, along with the price of the underlying asset. Typically used for the entire investment portfolio.
Full - used when there is an increased risk of loss of profit. This hedging type applies to the entire amount of the transaction and is necessary to completely eliminate the risk.
Partial - only a fraction of the total transaction amount is hedged. It is usually used if the risk of adverse price changes is low.
Net - the transaction uses a financial instrument based on the underlying asset, which is the object of the underlying transaction.
Cross - the transaction uses a financial instrument that correlates with the underlying asset (or its derivative). The direction of the transaction can either coincide with the direction of the transaction with the underlying asset or go in the opposite direction.
Unilateral – the entire profit (loss) falls on one party to the transaction. Note that it is impossible to predict in advance which side this will turn out to be as it all depends on the process and the result of the transaction itself.
Bilateral - this type of hedging involves sharing of profits (or losses) between both parties to the transaction.
Selective - a very flexible type of hedging characterized by the absence of strict correlations between the time and volume of transactions in underlying assets or futures. If, for example, a transaction lasts for a significant period of time, it is necessary to hedge the risks for this entire period, considering that the financial market is dynamic and constantly changing.
Difference between hedging and insurance
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.