If we had to sum up the word hedging in a few terms, you could probably trim it down to mitigating risk. That is, in essence, the reasoning behind a Forex hedging strategy. The classic meaning of a hedge is a position made by a market participant to reduce their exposure to price movements.
For example, the inherent cost of doing business exposes an airline to price fluctuations. An airline may decide to buy oil futures to mitigate the risk of rising fuel prices. They would be able to focus on their core business of flying passengers.
They have thus hedged their exposure to fuel prices. In this sense, a hedger is the polar opposite of a speculator. The hedger takes a position to remove or reduce risk, whereas the speculator takes a position on profitable risk in the hopes of being profitable.
But is it possible to have your cake and consume it?
Is there a guaranteed no-loss Forex hedging strategy where you can take positions to make a profit while mitigating your risk? While it is unfortunately not possible to completely remove risk, many different Forex hedging strategies aim to do so to different degrees.
The trick of any Forex hedging strategy or technique is to ensure that the trades used to hedge your risk do not wipe out your potential profit. The first strategy we will look at in this article wants a market-neutral position by diversifying risk. The 'Hedge Fund Strategy' is this. Because of its complexity, we will not look too closely at the specifics but will instead discuss the general mechanics.
Market-Neutral Position Through Diversification
To seek profits while being exposed to minimal risk, hedge funds exploit the ability to go long and short. Targeting price asymmetry lies at the heart of the strategy. Generally speaking, such a hedging strategy tries to do two things:
- Trading with multiple correlated instruments can reduce exposure to market risk.
- Profit from price asymmetries.
This strategy assumes prices will eventually revert to the mean, yielding a profit. In other words, this strategy is a type of statistical arbitrage. The trades are constructed to have an overall portfolio that is as market-neutral as possible. That is to say, price fluctuations have little effect on the overall profit and loss.
You are hedging against market volatility, which is another way of describing this. One significant advantage of such strategies is that they are intrinsically balanced. In theory, this should protect you from a variety of risks. In reality, however, maintaining a market-neutral profile constantly is very difficult.
Why is this the case?
For starters, correlations that exist between instruments may be dynamic. As a result, it is a challenge to merely stay on top of monitoring the relationships between instruments. Acting on the information promptly and without incurring significant transaction costs is a further challenge. Using large numbers of stock positions, hedge funds frequently employ such strategies.
Regarding stocks, there are distinct and obvious commonalities between companies in the same industry. For a Forex hedging strategy, finding such near commonalities with currency pairs is more difficult. There are also fewer instruments available.
How to Hedge Risk
Derivatives is another way to hedge risk is to use created with this risk in mind. Options are one type of derivative, and they are a fantastic tool. An option is a derivative that functions similarly to an insurance effect. As such, it has many applications when it comes to hedging strategies. Options are a complex subject, but for simplicity, we'll try to keep it simple. We need to introduce some options terminology to know how they can help with our foreign exchange hedging strategies.
First, let's define an option: An option is not an obligation but a right to trade a currency pair at a fixed price on a future date. The right to buy is termed a 'call' option. The "put" option is just a right to sell. The 'strike price' is the nominated price at which the option entitles you to trade, and the expiry date is the set date in the future. As an illustration:
Like anything traded in a competitive market, the 'price' or 'trade' of an option is governed by supply and demand. However, we can divide the value of an option into two components:
- Its intrinsic value
- Its time value
If exercised on the market, an option's value is known as its intrinsic value. A call has intrinsic value only if its prices are less than the underlying asset's current price as set. The opposite is right for a put option. Only when its current price is greater than the underlying asset's current price will a put exercise have intrinsic value. An option is called to be "in the money" if its intrinsic value is not zero. Rather, it is greater than zero. An option is called to be 'out of the money' if its intrinsic value is zero. However, the price of an option will frequently exceed its intrinsic value.
Some market participants completely hedge to reduce risk. They are willing to forego the possibility of making speculative gains in exchange for removing their price exposure. Speculators are not 100% happy doing this. To me, the best forex hedging strategy for them will almost certainly be:
- Retain some elements of the profit potential.
- In exchange for downside protection, make some trade-offs in terms of profit.
Options are a useful tool for hedging, as we saw in our example. However, their complexity makes them better suited to traders with more advanced knowledge. Options provide the versatility to set up a variety of hedging risk profiles. This allows you to fully tailor your Forex hedging strategy to your risk attitude.