If you’re into trading the capital markets, you’ve heard of hedging as a risk-minimization strategy. Forex hedging is a popular approach that works like insurance and protects you against market swings due to political or economic instability. But the question is: is Forex hedging profitable?
Yes, Forex hedging is profitable because it helps you counteract the risks of losing money in a market position. It’s a risk-minimization strategy that protects an open Forex position by buying the opposite side of the same trade. So, the trader’s profit equals the risk they avoid.
In the rest of the article, we’ll discuss various hedging strategies and their advantages and disadvantages. We’ll explain if hedging with Forex is profitable and legal. We’ll also talk about when it’s best to engage in hedging.
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Table of Contents
What Is Hedging in Forex?
Hedging, in general, means protecting oneself from possible future risks. For example, when someone buys fire insurance, they’re protecting, or hedging, their property against possible fire in the future. The practice isn’t only common among trading institutions; ordinary people do the same thing when they try to avoid losing their money due to reductions in currencies by buying gold, for instance.
Hedging with Forex means coming up with a strategy to offset the risk of losing money due to possible movements on a currency pair. It technically involves opening a position on that currency pair to protect their position or protect against an unpredictable or unwanted move in exchange rates.
Although hedging is possible in all markets, it’s more common in the Forex market due to its higher volatility. If a trader doesn’t want to close out an existing position, they can open a second pair as a hedge.
In Forex trading, a trader protects their investment from market swings by adopting a conservative strategy that doesn’t lead to a considerable loss or profit. Traders perform hedging in different ways.
Types of Hedging in Forex
Direct Hedging
It involves opening two positions on one currency pair. For example, if you have a long position on USD/JPY, you’ll open a short position on USD/JPY. These positions are the same in size, with inverse correlations between the price movements. So, any changes in these positions’ prices move in opposite directions, which means they can cancel each other.
Complex or Multiple Hedging
It needs more experience in trading and is possible through different approaches. One way is to open one or several positions in two negatively correlating currency pairs. It’s more effective when you’re trading in several currency pairs.
Another approach is to buy a long position in one currency and an opposite short position in another currency. For example, suppose you buy a short position in the GBP/JPY market and a long USD/GBP position. Therefore, you’re safe against GBP exposure. However, if movements occur in other currencies, you have no protection in those currencies. So, if the USD or JPY has any chance of fluctuation, you’ll be exposed.
How Traders Hedge Trades in Forex?
Traders can hedge with Forex using different instruments such as options or futures:
- Currency options are contracts that allow a buyer to trade a specified currency at or before a particular date. The buyer has the right but isn’t obligated to do so.
- Futures are legally binding contracts that determine the price at which one currency will be exchanged for another at a future date.
- Traders from some countries can hedge against their trades in the Forex spot market as well.
Forex hedging can be partial, which protects against some of the impacts of an adverse move. Or, it can be complete, which involves complete protection against any future fluctuations.
Is Hedging Illegal?
Forex hedging is legal in Asia, Australia, and the European Union. But it’s illegal in the US, where the law bans trading one currency pair at either different or the same strike prices. Therefore, Forex traders have to act based on the Commodity Futures Trading Commission (CFTC) rules.
To ensure traders can’t hedge positions on one currency pair, the CFTC has obligated brokers to use OCO (One Cancels Other) order in their platforms.
Another rule that limits hedging is the FIFO rule. It prevents traders from hedging by making them liquidate their positions in the same order they opened them.
Is Hedging Profitable?
Forex hedging can be profitable if done right. However, its primary benefit isn’t profitability. Instead, hedging is popular among traders because it lowers risks and protects the trader against unfavorable market conditions.
Described below are a few important considerations to make when exploring to leverage hedging in trading the Forex markets.
Reducing Risk
Traders benefit from hedging by being able to minimize their losses, especially when markets are volatile.
Although traders could simply close and liquidate their positions, hedging allows them to buy some time and wait and see how conditions will change over time. This way, they can balance profits and losses while maintaining their positions and collecting more information. Therefore, if they lose money on one currency, they can cash out their earnings from the other one.
Protection
Hedging is a universal strategy with a wide range of instruments and approaches. Traders can use a combination of strategies to ensure the highest protection possible.
And even if they can’t achieve full protection, partial protection is possible. Plus, traders can engage in risk diversification by “not putting all eggs in one basket.” It involves effective division of assets based on the correlation of their prices.
Profitability Risks
However, many factors make the profitability of hedging controversial. Amateur traders, in particular, should be cautious when using hedging strategies.
- One of the main disadvantages of hedging is that it costs twice as much as opening a regular trade. So, if the trader doesn’t have enough experience or can’t enter and exit the market at the right time, they’ll be at a great loss due to these costs.
- Trading outcomes often aren’t significant enough and are more profitable to the broker than the trader.
- Every order incurs commissions, spreads, or swaps, which may cause traders to lose more than their trading capital.
- Since Forex hedging is complex, traders can’t fully predict the future fluctuations in the market and may not offset potential losses. Even if they design their hedges carefully and properly, there’s still some chance that both currencies generate a loss.
- Price volatility is an essential factor that traders should consider in timing their trades. If traders, no matter how experienced, adopt complex hedging strategies, they should be aware of how poor timing affects potential losses in the future.
The most crucial factor to consider is that hedging reduces risks and profits simultaneously and to the same extent. The only profit you make is by avoiding a possible loss.
What’s the Best Time To Hedge?
Hedging is possible whenever you don’t want to close an open position and try to counteract the risk in that condition.
Sometimes there’s uncertainty over factors that create volatile price movements. For example, the trader doesn’t know if a certain asset is overbought; or political instability could affect price reductions in specific pairs. These concerns are critical when the positions on those pairs are long. In such cases, a short-term hedge can be effective.
However, if you’re not a full-time trader or your account isn’t large enough to be highly profitable despite limited profits, hedging may not be the best option for you.
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Conclusion
Forex hedging is a prevalent tool to protect against price volatility and incurred risks. It involves offsetting a potential loss by identifying future trends in a currency and buying a currency in the opposite direction.
If a trader has enough experience to understand market changes and knows when to engage in hedging, it can be advantageous. Although it can’t bring much profit to your portfolio, you can make sure that you have limited the risks.
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