How to Trade Using a Forex Hedging Strategy
If we had to sum up hedging in as few words as possible, we could probably trim it down to just two: mitigating risk. That, in essence, is the thinking behind a Forex hedging strategy. The classic definition of a hedge is this: a position taken by a market participant in order to reduce their exposure to price movements.
For example, an airline is exposed to fluctuations in fuel prices through the inherent cost of doing business. Such an airline might choose to buy oil futures in order to mitigate against the risk of rising fuel prices. Doing so would allow them to focus on their core business of flying passengers.
By doing this, they have hedged their exposure to fuel prices. In this sense we can say that a hedger is the opposite of a speculator. The hedger takes a position to reduce or remove risk, whereas a speculator takes on price risk in the hopes of being profitable.
But is there a way to have your cake and eat it?
Is there a guaranteed no loss Forex hedging strategy where you can take positions with the intention of achieving profit, but also mitigating your risk simultaneously? Whilst, unfortunately, it is not possible to completely remove all risk, there are a vast number of different Forex hedging strategies that aim to do this to varying degrees.
The real trick of any Forex hedging strategy or technique is to ensure that the trades that hedge your risk do not wipe out your potential profit. The first such strategy we will look at in this article seeks a market-neutral position by diversifying risk. This is what is known as the 'Hedge Fund Approach'. Because of its complexity, we are not going to look too closely at the specifics, but instead discuss the general mechanics.
Market-Neutral Position Through Diversification
Hedge funds exploit the ability to go long and short, in order to seek profits whilst being exposed to minimal risk. At the heart of the strategy is targeting price asymmetry. Generally speaking, such a hedging strategy aims to do two things:
- Stave off exposure to market risk by trading with multiple, correlated instruments
- Exploit asymmetries in price for profit.
This strategy relies on the assumption that prices will eventually revert to the mean, yielding a profit. In other words, this strategy is a form of statistical arbitrage. The trades are constructed so as to have an overall portfolio that is as market-neutral as possible. That is to say, that price fluctuations have little effect on the overall profit and loss.
Another way of describing this is that you are hedging against market volatility. A key benefit of such strategies is that they are intrinsically balanced in nature. In theory, this should protect you against a variety of risks. In practice, however, it is very hard to constantly maintain a market-neutral profile.
Why is this?
For a start, correlations which exist between instruments may be dynamic. Consequently, it is a challenge simply to stay on top of measuring the relationships between instruments. It is a further challenge to act on the information in a timely manner, and without incurring significant transaction costs. Hedge funds tend to operate with such strategies using large numbers of stock positions.
With stocks, there are clear and easy commonalities between companies that operate in the same sector. Identifying such close commonalities with currency pairs for a Forex hedging strategy is not as easy. Furthermore, there are fewer instruments to choose from.
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Options Trading in Hedge Strategies
What Is an Option?
Another way to hedge risk is to use derivatives that were originally created with this express purpose in mind. Options are one such type of derivative and they are an excellent tool. An option is a type of derivative that effectively functions like an insurance policy. As such, it has many uses when it comes to hedging strategies. Options are a complex subject, but for the sake of simplicity, we will try to keep this to a basic level. That being said: in order to discuss how they can help with our foreign exchange hedging strategies, we need to introduce some options terminology.
First of all, let's define what an option is: An FX option is the right, but not the obligation to buy or sell a currency pair at a fixed price at a set date in the future. The right to buy is called a 'call' option. The right to sell is called a 'put' option. The fixed price at which the option entitles you to buy or sell is called the 'strike price' or 'exercise price' and the set date in the future is called the expiry date. For example:
- A 1.3500 GBP/USD call is the right to buy one lot of GBP/USD at 1.3500.
The 'price' or 'premium' of an option, as with anything traded in a competitive market, is governed by supply and demand. We can, however, consider the value of an option to consist of two components:
- Its intrinsic value
- Its time value
An option's intrinsic value is how much it is worth if it is exercised in the market. A call will only have intrinsic value if its exercise prices are less than the current price of the underlying asset. The opposite is true for a put option. A put will only have intrinsic value if its exercise price is greater than the current price of the underlying asset. An option with an intrinsic value of more than 0 is said to be 'in the money'. If an option's intrinsic value is 0, it is said to be 'out of the money'. An option's price will often exceed its intrinsic value though.
Why is that?
An option offers protective benefits to its buyer. Because of this, traders are willing to pay an added amount of time value. All things being equal, the more time left to an option's expiry, the greater its time value. Consider our 1.3500 GBP/USD call example from before. The spot GBP/USD rate is the underlying asset.
If the underlying asset is trading at 1.3250, for example, our call is out of the money. Its intrinsic value is 0. However, if the GBP/USD is trading at 1.3650, our call option has an intrinsic value of 150 pips. That's because if we exercised the option, we could buy GBP/USD at 1.3500, the exercise price of our call.
This would allow us to sell at the underlying price of 1.3650, for a profit of 150 pips. Having ran through these basics, let's look at how we can use options as part of a Forex hedging strategy for protection against losses. The interesting thing about options is the asymmetrical way in which their price changes as the market goes up or down.
A call option will increase in value, as the market rises with no ceiling. But if the market falls, the call's premium can go no lower than 0. This means that if you bought the call, you have an unlimited upside, with a strictly limited downside. This opens the door to a wealth of possibilities when it comes to your Forex hedging strategy.
Let's look at a simple example: buying an option as a protection against price shocks. Let's say you are short on the AUD/USD currency pair. You've taken the position to benefit from the current negative interest rate differential between Australia and the US. For example, if the short swap value is +0.17 pips, this means that every day you are short on the trade, you are gaining interest. However, holding the position also exposes you to price risk.
If the currency pair moves sideways, or drops, you are going to be fine. But if its net movement is upward more than an average of 0.17 pips per day, you are going to make a loss. Your real concern is a sharp rise, which could significantly outweigh any gains made from the positive swap.
So how do you mitigate this price risk?
One of the easier ways is to buy an AUD/USD call that is out of the money. Because the option is out of the money, it's premium will only consist of time value. The further out of the money, the cheaper the premium you will have to pay for the call. The risk profile of a call is that you have a fixed cost (i.e. the premium you pay to buy the call). But once you have paid this, it provides protection against sharp upward movements. Let's work through some numbers:
Let's say that you sold one lot of AUD/USD on 1 September 2020, when the price was 0.7372. You took the short position as a carry trade to benefit from the positive swap. However, you want to protect yourself against the risk of a sharp move to the upside. You decide that the best way to hedge the risk is to buy an 'out of the money' call option. You buy the 0.7600 call with a three-month expiry at a price of 0.0030, or 30 pips.
At expiry, the 0.7600 call will be worth something if the underlying price has risen above 0.7600. By buying the call, you have reduced your maximum downside on your short trade to just 228 pips. That's because the intrinsic value of your call starts increasing once the market rises above its exercise price. Your overall downside is: the 228 pips between your short position and the exercise price, plus the cost of the call. In other words, a total of 258 pips. The diagram below shows the performance of the strategy against the price at expiry:
You can think of the option's cost as equivalent to an insurance premium. Following on from this analogy: the difference between the exercise price and the level at which you are short on the underlying, is a bit like a deductible of the insurance policy.
Want to know the best bit?
Your upside has (theoretically) no limit ('theoretically' since the value of AUD will very unlikely drop to 0). As long as AUD/USD keeps dropping, you will keep making profit. To continue our example: let's suppose that the AUD/USD rises to 0.7900 at expiry. You will have lost 528 pips on your short position. But your call, the right to buy AUD/USD at 0.7600, must be worth 300 pips. Therefore, you have lost only 228 pips.
Add in the 30 pip cost of the option's premium in the first place, and your total downside is 258 pips, as stated above. No matter how far the AUD/USD rises, this number never increases. Now let's suppose that the AUD/USD is dropping to 0.6900 at expiry. You make 472 pips on your short position, but your option costs 30 pips. Overall, you make the difference, which is 442 pips of profit.
A Final Word on Using a Forex Hedging Strategy
Hedging is always something of a balancing act. The act of hedging delays the risk, but the compromise is in how this affects your potential profit. As stated earlier, some market participants hedge in order to completely reduce their risk. They are happy to give up their chance of making a speculative profit, in exchange for removing their price exposure. Speculators are not entirely happy doing this. The best forex hedging strategy for them will likely:
- Retain some element of profit potential
- Contain some tradeoff in terms of reduced profit, in exchange for downside protection.
Options are an extremely useful tool for hedging, as we saw from our example. Their complexity however, means that they are better suited to traders with more advanced knowledge. Options offer the versatility to set up a variety of hedging risk profiles. This allows you to fully tailor your Forex hedging strategy to properly suit your attitude to risk.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of, or recommendation for, any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.
