How to Start Hedging Forex.
Hedging currency positions or other forms of exposure to the forex (foreign exchange) market is a skill that can take some time to learn depending on the kind of protection you need. If you are looking to learn about hedging and the best way to mitigate forex risk, then read on before executing a currency hedge position.
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Table of Contents [ Show ]
What is Hedging in Forex? How Does Forex Hedging Work? Risks Associated with Hedging Forex The Best Brokers to Hedge Forex With Quick look: Best Brokers for Hedging Forex 3 Best Hedging Forex Brokers Should You Hedge Forex Risk? Compare Forex Brokers.
What is Hedging in Forex?
Once you start trading forex or if you have a fundamental currency exposure that arises, you might feel the need to protect against market risk without closing out your position entirely.
“Hedging” is protecting yourself against risk, and the transaction that you execute to do so is a “hedge.” Hedges can fully or partially protect you against market risk by having an offsetting market exposure to your original position.
In many cases, a partly-offsetting spot transaction is suitable to hedge a spot forex position in a currency pair during an undesirable risk period. If an undesirable forex risk is longer than the spot delivery date, then currency products like forwards, futures and options contracts can be used as effective hedges.
Some retail forex traders use the term “hedging” specifically to refer to having an open but offsetting position in a currency pair with their online broker. This practice is not allowed in some countries, most notably the U.S., for example, where retail traders are expected to simply close out the initial position rather than hedge it by keeping two offsetting positions open in the same currency pair.
How Does Forex Hedging Work?
Unless they focus entirely on trading, most forex trading courses will have a section on hedging. While less common among traders who actually want to take forex risk, the idea of reducing forex risk via hedging is especially popular among businesses that view currency hedging as a prudent risk management strategy. Companies generally prefer not to take significant risks they don’t understand or have the in-house skills required to manage actively.
Hedging a Spot or Forward Position.
Consider the gains and losses associated with a hedged position in which a trader is long 1 million euros for value spot and has hedged that position with a short 1 million euro transaction also for value spot so that their net exposure is 0. A forward contract could be used instead of a spot contract when hedging a known exposure for a value date beyond spot.
If the EUR/USD exchange rate moves from 1.2500 to 1.3000, then their +$50,000 in profits on the initial long euro position are completely offset by their -$50,000 in losses on the short euro hedge position.
Hedging a Contingent Exposure Using an Option.
Hedging an exposure using a long option contract gets a bit more complicated and is typically most appropriate for hedging contingent exposures that may occur. This uncertainty is typically because the exposure depends upon something happening, like a business possibly getting a contract in a bidding contest.
In this example, consider the situation if the contingent exposure is for the need to buy 1 million euros at 1.2500 and will persist over 1 month of bidding. This gives the company a possible short exposure to the EUR/USD exchange rate at the contractual rate, and it can then purchase a 1month euro call/U.S. dollar put option with a strike price of 1.2500 to hedge their risk in case they win the contract.
If the market ultimately ends up above the 1.2500 strike price at expiration, then the option will be exercised or sold back, but it will be abandoned as worthless if the market ends up below that rate. Like an insurance policy, that option purchase will cost the business a premium. The premium’s value will depend on the prevailing spot rate and the 1- month forward rate and implied volatility for EUR/USD, among other factors.
The EUR/USD put option has a breakeven rate of 1.2500 plus the option premium that was paid converted into the same terms as the exchange rate. So if a premium of $30,000 was paid, that conversion is 0.0300 based on the following calculation:
$30,000 premium/1 million euros notional amount = 0.0300 U.S. dollars per euro.
Adding that 0.0300 to the option’s contractual exchange rate or strike price of 1.2500 yields a breakeven rate of 1.2800.
Using their option, the company can buy 1 million euros at 1.2500 if the market rises and the exposure materializes, but if the exposure does not materialize because the bid is lost, then the option can be sold back for whatever it is worth once that situation becomes clear.
Risks Associated with Hedging Forex.
The risks associated with hedging a forex position are generally lower than those you would take if you remain unhedged. However, if you do not hedge fully, or if an expected exposure fails to materialize, then you can be exposed to risk from a hedge just like you would if you had taken that net position as a speculative trade.
Another risk associated with hedging is that the underlying position might have turned out to be profitable, but using a hedge fully or partially eliminated that profit. This results in a disappointing missed opportunity, a worse competitive position when bidding, or even criticism from management about how the forex risk was handled.
When a Forex Hedge Works.
Since hedging is generally aimed at reducing risk, risks with forex hedging are generally lower than those you would take if you allowed the initial position to remain unhedged. Hedging therefore usually works well if the initial position or underlying exposure would have lost money because the hedge compensates you for that loss.
When a Forex Hedge Doesn’t Work.
Using a hedge is often more controversial when your underlying position or exposure ultimately turns out to benefit from the exchange rate movement seen afterward. This opportunity loss r could reduce competitiveness for a business due to the loss you’ll need to take on a hedge.
The Best Brokers to Hedge Forex With.
If you are a retail online trader, then selecting the best forex broker to hedge a currency position may depend on where you live. While traders living outside the U.S. can generally hedge while trading, U.S.-based traders typically are not allowed to run offsetting positions with an online broker regulated by the National Futures Association (NFA).
An NFA rule known as the first-in-first-out (FIFO) rule -- formally known as NFA Compliance Rule 2-43b -- prohibits this hedging. The NFA’s FIFO policy means that retail forex traders need to close their earliest transactions out first when their active trades involve the same forex pairs in the same position size. It also bans price adjustments to executed customer orders, except to resolve a complaint. Note that this rule does not apply to outright currency positions hedged with option contracts.
We recommend you check out the following brokers:
Quick look: Best Brokers for Hedging Forex.
3 Best Hedging Forex Brokers.
Benzinga compiled a list of the best forex brokers that allow hedging. Take a look at our top picks.
1. FOREX.com.
FOREX.com is a top U.S.-based forex broker, but since it is regulated by the NFA, you cannot use this broker to take on hedging positions in the same trading account if you are based in the U.S.l.