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Hedging forex: 4 strategies to offset currency risk

Forex hedging is the process of opening multiple positions to offset currency risk in trading. The foreign exchange markets can be affected by adverse conditions, such as changing interest rates or inflation, so traders aim to protect their open positions by bulling or selling additional assets to reduce the overall risk of exposure.

This article explores four of the most common and effective forex hedging strategies, taking into account our derivative products. Traders tend to use currency hedging instruments such as cross currency swaps, forward contracts and forex options. Hedging forex can be put to practise through the two main products on our online trading platform: spread betting and CFD trading.

What does hedging mean in forex?

Forex hedging is the act of reducing or preventing losses that occur from unexpected events within the FX market. Hedging strategies can be applied to all financial markets, but in particular, forex is the most common, given the number of influencing factors.

The forex market is the largest and most liquid financial market in the world, and with over 330 forex pairs available on our online trading platform, there is no shortage of foreign currencies to trade. Forex traders have therefore created various forex hedging strategies in order to minimise the level of currency risk that comes with various economic indicators.

Forex brokers offer financial derivatives to hedge against currency risk, which are typically over-the-counter products. This means that they do not trade on a centralised exchange and in some cases, derivatives can be customised at a certain point throughout the duration of the contract. However, OTC trading is not regulated and is generally seen as less safe than trading via an exchange, so we recommend that our traders have an appropriate level of knowledge before opening positions.

  • Why not practise your forex hedging strategy with us on a demo account? This allows you to develop your hedging skills with £10,000 worth of virtual funds, which is a totally risk-free approach to trading.

Currency hedging

Currency hedging (another term for forex hedging) is when a trader enters a contract that will protect them from interest rates, exchange rates or other unexpected changes in the forex market. Hedging currency pairs can include major crosses, such as EUR/USD and USD/JPY, but also minor and exotic pairs. This is because the forex market can change direction in the face of political or economic events in any country, causing each currency to either rise or decline in value.

So, how do you hedge currency risk? Read on to see how hedging works in forex.

Hedging forex

How to hedge currency risk

In order to hedge currency risk, this usually requires an expert level of knowledge from those who appreciate the risks of trading within such a volatile market. However, beginner traders can learn the process of forex trading with determination and an understanding of how the market works.

Consult our step-by-step guide on forex for beginners in order to prepare. We would also recommend that our clients follow our news and analysis section, where our dedicated market analysts provide frequent updates and announcements. In this case, this will help you to learn and anticipate movements that happen within the forex market.

Forex hedging strategies

Hedging forex with options

FX options are a form of derivatives products that give the trader the right, but not the obligation, to buy or sell a currency pair at a specified price with an expiration date at some point in the future. Forex options are mainly used as a short-term hedging strategy as they can expire at any time. The price of options comes from market prices of currency pairs, more specifically the base currency.

Let’s say that a trader decides to make a ‘call option’ and buy an amount of EUR/USD, but thinks that there may be a fall in price. He can then make a ‘put option’ and short-sell an equal amount of foreign currency at the same time in order to profit from the fall in price. This way, the trader is hedging any currency risk from the declining position and this is more likely to protect him from losses.

Forward currency contracts

Another financial derivative is a forward contract. Similar to FX options, forward trading is a contractual agreement between a buyer and seller to exchange currency at a future date. Unlike a call option, the buyer has an obligation to purchase this asset and there is more flexibility for customisation. Traders can settle forward currency contracts on a cash or delivery basis at any point during the agreement, and can also change the future expiration date, the currency pair being traded and the exact volume of currency involved. Some traders prefer this method of derivative trading as it proposes slightly less risk, especially in the context of currency hedging.

Hedging with currency futures follows an almost identical process to that of forwards, apart from the fact that they are traded on an exchange.

Cross currency swap hedge

A cross currency swap is an interest-rate derivative product. Two counterparties (often international businesses or investors) agree to exchange principal and interest payments in the form of separate currencies. They are not traded on a centralised exchange in a similar way to forwards or futures, meaning that they can be customised at any point and rarely have floating interest rates. These floating rates can fluctuate depending on the movements of the forex market.

The purpose of a cross currency swap is to hedge the risk of inflated interest rates. The two parties can agree at the start of the contract whether they would like to impose a fixed interest rate on the notional amount in order not to incur losses from market drops. The consideration of interest rates here is what separates cross currency swaps from derivative products, as FX options and forward currency contracts do not protect investors from interest rate risk. Instead, they focus more on hedging risk from foreign exchange rates.

Cross currency swap hedges are particularly useful for global corporations or institutional investors with large volumes of foreign currency to exchange.

Forex correlation hedging strategy

It is a well-known fact that within the forex market, there are many correlations between forex pairs. Pairs trading is an advanced forex hedging strategy that involves opening one long position and one short position of two separate currency pairs. This second currency pair can also swap for a financial asset, such as gold or oil, as long as there is a positive correlation between them both.

Forex hedgers can use pairs trading in the short-term and long-term. As it is a market neutral strategy, this means that market fluctuations does not have an effect on your overall positions, rather, it balances positions that act as a hedge against one another. Forex correlation hedging strategies are particularly effective in markets as volatile as currency trading. Pairs trading can also help to diversify your trading portfolio, due to the multitude of financial instruments that show a positive correlation.

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Forex hedging strategy

How to hedge currency

  1. Open an account. It is a simple process to open a live account and start trading now. Alternatively, you can practise your forex hedging techniques risk-free on a forex demo account.
  2. Choose a currency pair. We offer over 330 forex pairs to trade, including major, minor and exotic crosses. If you want to take advantage of market volatility, you may want to choose a foreign currency that is experiencing changes in inflation, interest rates or GDP of the country.
  3. Determine your forex hedging strategy. Whether this be one of the four mentioned above, or a completely different strategy, you should build a thorough plan with an end goal.
  4. Keep up to date with forex news.Trading on forex news and economics announcements can be a useful strategy for forex traders, as the market is constantly changing. Our economic calendar can be customised to your personal preferences and it will highlight any upcoming events that may have an effect on your positions.
  5. Download our mobile app. You can opt to receive price alerts when your chosen currency pair has reached a specific level or price. You can also receive notifications on your desktop in order to take advantage of trading opportunities in the moment.
  6. Define your entry and exit points and place a trade. Look out for forex signals and make use of the many technical indicators that are available on our platform in order to build a strong technical analysis strategy.
  7. Use appropriate risk management. We have a number of stop-loss and take profit orders that are available to prevent loss of capital as much as possible. Read more about our execution types here.

Forex hedging example

Let's take an example of a political situation, say, trading the US election. We could use a forex correlation hedging strategy for this, which involves choosing two currency pairs that are directly related, such as EUR/USD and GBP/USD.

If you are looking to hedge your USD exposure, you could open a long position for GBP/USD while shorting EUR/USD. This means that if the dollar appreciates in value against the euro, your long position would result in losses, but this would be offset by a profit in the short position. On the other hand, if the dollar were to depreciate in value against the euro, your hedging strategy would help to offset any risk to the short position.

Forex hedging software

Our online trading platform, Next Generation, makes currency hedging a simple process. Complete with technical indicators, chart forums and price projection tools, our forex hedging software can provide traders with every source of information that they need to get started in the forex market.

You can also take advantage of our mobile trading apps, including software for both Apple and Android. It is easy to trade while you are on the go, without the comfort of your home desktop.

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Disclaimer: CMC Markets is an execution-only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person. CMC Markets does not endorse or offer opinion on the trading strategies used by the author. Their trading strategies do not guarantee any return and CMC Markets shall not be held responsible for any loss that you may incur, either directly or indirectly, arising from any investment based on any information contained herein.

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