Trading 101: What is Hedging in Forex?
What is hedging?
Hedging in financial markets is a trading technique used to protect yourself against major losses. It’s a popular form of risk management used by traders and can be thought of as an insurance policy against your trades in the event of an adverse movement. Hedging in forex involves opening a buy position and a sell position on the same currency pair. This is known as direct hedging or a perfect hedge and protects traders against a movement either way. It essentially eliminates all risk but also eliminates any profits.
Not all hedging is this simple though. A trader may decide to open a buy position and a sell position on two different currency pairs that are positively correlated. In other words, the two currency pairs usually move in the same direction. For example, the EUR/USD and GBP/USD generally move in the same direction, as do the AUD/USD and NZD/USD. This is known as indirect hedging. For another example, you might open a long position on AUD/USD with the belief the AUD would strengthen, and the USD would weaken and at the same time, you would open a short position on the NZD/USD to protect yourself against a rise in the USD.
Everyday examples of hedging
Hedging is a technique that can be applied to everyday activities, not just in trading. For instance, when a person purchases car insurance, they are protecting their vehicle against accidents or theft. That person may never have an accident and their car may never be stolen, but the insurance policy is a form of risk management, protecting the person from financial loss if an accident did occur. In fact, any form of insurance can be compared to hedging financial products.
Benefits of hedging
The key benefit of hedging is to offset the risk of price fluctuations in the market, to protect your investments. Other benefits include:
- Different strategies: Traders can choose to hedge directly, indirectly, or via forex options contracts. Direct hedging can be executed on any currency pair.
- Mitigate loss: Safeguarding traders during hard and volatile market periods.
- Time-saving: Hedging means long-term traders don’t have to monitor or adjust their portfolio daily.
- Leverage: Margin and leverage can be used with hedging to magnify profits (but also magnify losses).
Disadvantages of hedging
Hedging is not without its disadvantages. If the strategy is not executed correctly, hedging can expose traders to financial risk.
- Restrictions: Some brokers do not allow direct hedging (placing a buy and a sell on the same currency pair). In fact, in the United States, hedging in forex markets is illegal.
- Reduced profits: Because hedging is used to protect traders against losses, it also reduces your profits. Money withdrawals are also not allowed during the hedge period.
- Patience: Hedging can be complicated and takes patience. Sometimes traders get stuck in a hedge for too long while waiting for a positive move and make irrational decisions.
- Fees: Like all trading strategies, there are fees involved with hedging. If your profits are already minimal, fees will eat into this.
Hedging Futures and Options
Up to now, we’ve discussed direct hedging and indirect hedging as an advanced strategy used in forex trading. But hedging is also vastly popular among futures and options traders. For example, a put option is a contract which gives the buyer a right, not the obligation, to sell a financial asset at a specified price and date. Because the buyer is not obliged to fulfil the contract, the buyer can allow the contract to expire if the financial asset moves against their favour. A put option is used when trading shares on a stock exchange. By executing a put option, the trader is hedging the stock against adverse movements.
A futures contract, on the other hand, is a contract between two parties to buy or sell an asset at a specific price and date. The buyer and seller are both obligated to fulfil this contract, unlike an options contract. A futures contract is useful for traders or companies who don’t have the funds to purchase the asset now or believe the asset will appreciate or depreciate in value by the contract date. By locking in a set price and date, the trader knows exactly how much they need to pay regardless of price fluctuations. For example, an oil producer may execute a futures contract if they believe the price of oil will go down in twelve months. That way the oil producer is guaranteed to sell its oil for an agreed upon price.
From oil to gold, commodities are one of the most commonly hedged financial instruments. Gold in particular is a popular choice for investors because the commodity is seen as a safe haven from riskier assets during economic or political uncertainty. This is why the price of gold surged during the Eurozone debt crisis in 2011. It’s used in hedging against stock markets, in case of a crash, and currencies (mainly the U.S. dollar). Gold can also be traded in the futures and options market, which is the most popular form of hedging with commodities. Commodities includes everything from gold and oil to wheat, soybeans and dairy.
What is a hedge fund?
Hedging can sometimes be confused with a hedge fund because of the shared title, but the two terms couldn’t be any more different. While hedging is a trading strategy, a hedge fund is a private partnership between a professional fund manager and their clients, who are usually high-profile investors. A hedge fund pools the money of its clients to invest in or trade shares, forex, commodities or derivatives. Hedge funds aim to reduce risk on investments, and therefore use hedging as a technique to reduce risk, hence the shared name.
The purpose of a hedge fund is to maximise the returns on client investments, whether financial markets are trading higher or lower. Generally speaking, hedge funds are designed to generate a consistent level of return. Fund managers are paid by charging a management fee along with commission on any profit made from the investments.
Hedge fund characteristics
Hedge funds are not typically used by your average retail trader. Managers target sophisticated investors and are characterised by the following:
- Wealth status: Hedge funds only target sophisticated investors with high net worth. Typically, investors must earn more than $200,000 per year and have a net worth of more than $1 million. They must also be accredited – or qualified investors – which means they possess a higher level on knowledge on the industry.
- Leverage: Hedge fund managers are aggressive in their trading strategies and usually adopt leverage as a method to amplify returns. Leverage uses borrowed funds to open larger positions. While the technique increases returns, it can also amplify losses, which is why hedge funds use hedging to safeguard client funds.
- Fees: Hedge fund fees differ to mutual fund fees and broker fees. Hedge funds charge clients a management fee as well as a performance fee (commission). For example, an asset management fee could be 2% of the total investment plus a 20% commission on any profits made from the pool of money.
- Regulation: Unlike mutual funds, hedge funds are not regulated by certain governments or exchanges. For example, hedge funds are not currently regulated by the U.S. financial industry watchdog known as the Securities and Exchange Commission (SEC).