The concept of forex hedging is primarily used by corporations to hedge their exposure to foreign exchange currency fluctuations, manufacturers and exporters are generally considered to be the most frequent users of hedging. The corporate world is not necessarily looking to profit from the currency forex transaction, more likely they’re looking to ensure that the transaction they’re conducting (in the destination export foreign country), isn’t adversely effected by the exposure to that other country’s domestic currency.
If a manufacturer of tractors in the UK, wishes to export their products to Europe, then they may take positions in the euro by (in effect) exchanging sterling, proportionate to their exporting volume, in order to prevent them losing some (or all) of their profit, when the transaction and exchange is measured and accounted for in their own domestic currency and their profit and loss ledger. Similarly, the manufacturer may import raw materials from the Eurozone into the UK to build the tractors, therefore they may use hedging when buying their materials.
Corporates will traditionally use the futures and options market to conduct this hedging strategy, as opposed to retail FX traders using the spot forex market. As with options on other securities, foreign currency options give the purchaser the right, but not the obligation, to buy or sell the currency pair at a particular exchange rate, set at some time in the future.
A textbook definition of hedging, a description that could be taught in global business schools,or to apprentice traders at investment banks, is that a hedge is an investment intended to offset any potential losses or gains that may be incurred by a companion investment.
How we can use hedging as part of our overall strategy
With foreign exchange traders and retail forex traders in particular, our use of hedging is slightly different; we’re still looking to protect our positions, but also protect our profit. We’ll now use an example of how we can use hedging as part of our overall strategy/trading method in our retail forex trading. Let’s use the UK’s 2016 June Brexit referendum and its effect on sterling.
So you may be a swing and or position trader, who had positions in the market such as: short EUR/GBP, USD/CHF and long GBP/CHF. Rather than simply close your sterling bets prior to the referendum vote, you decide to sell GBP/USD to hedge; you’re selling pounds whilst buying dollars and your existing positions are long sterling and short dollars. There are other pairs you could have chosen and using a correlation table (many of which are available free of charge on the web and on MetaTrader) can help with this. A near perfect negative correlation should be looked for, for example, tradition reveals that USD/CHF ‘versus’ EUR/USD has an extremely reliable negative correlation history.
It’s important to bear in mind that retail traders are in most instances using hedging to protect a certain level of profit in their positions and not necessarily to always prevent any loss. If we adopt a neutral no loss hedging strategy to our trading then (in theory) we’d never make a profit. Therefore in the example we’ve quoted, we don’t sterilise our overall position by cancelling it out by using hedging, we simply limit our potential exposure to a loss. We could (in theory) completely protect ourselves as each high impact calendar event is released, but once again this could potentially diminish our profit per trade and overall position in the market.
Hedging is a concept and subject worth considering and experimenting with, we’ve only given a brief introduction here of what is quite a complex subject. As with many issues regarding trading, its usefulness depends on the trading strategy individual traders use, in particular their style of trading. It’s therefore worth individual traders taking time out to do their own research as to the viability and suitability of hedging based on their individual trading styles.