How to use a Forex hedging strategy to look for lower-risk profits

If we had to sum up hedging in as few a words as possible, we could probably trim it down to just two:

...mitigating risk.

That, in essence, is the thinking behind all hedging strategies.

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 by 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.

They have hedged their exposure to fuel prices.

For a fuller explanation about this kind of hedging, take a look at our article explaining what Forex hedging is.

In this sense, a hedger is the opposite of a speculator.

The hedger takes a position to reduce or remove risk, as we have said.

This is in contrast to a speculator, who takes on price risk in the hopes of making profit.

But is there a way to have your cake and eat it?

Are there no loss Forex hedging strategies and techniques where you take positions with the intention of profit, but also mitigate your risk?

While it's not truly possible to remove all risk, the answer is yes.

There is a number of different Forex hedging strategies that aim to do this to varying degrees.

The real trick of any Forex hedging technique and strategy is to ensure the trades that hedge your risk don't wipe out your potential profit.

The first Forex hedge strategy we're going to look at seeks a market-neutral position by diversifying risk.

This is what I call the hedge fund approach.

Because of its complexity, we aren't 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 while only being exposed to minimal risk.

At the heart of the strategy is targeting price asymmetry.

Generally speaking, such a strategy aims to do two things:

stave off exposure to market risk by trading in multiple, correlated instruments exploit asymmetries in price for profit.

The 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?

Well, correlations between instruments may be dynamic, for a start.

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 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 is not so easy.

Furthermore, there are fewer instruments to choose from.

The good news is that MetaTrader 4 Supreme Edition comes with a Correlation Matrix, along with a host of other cutting-edge tools.

This makes it easier to recognise close relationships between pairs.

Using options trading in hedging strategy

Another way to hedge risk is to use derivatives that were originally created with this express purpose.

Options are one of these types of derivative and they make 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 we'll try to keep this to a basic level.

That said: 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… a fixed price at some 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.

The set date in the future is called the expiry date.

So, for example:

...a 1.2900 GBP/USD call is the right to buy one lot of GBP/USD at 1.2900.

The price or premium of an option is governed by supply and demand, as with anything traded in a competitive market.

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 exercised in the market.

A call will only have intrinsic value if:

...its exercise prices is less than the current price of the underlying.

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.

An option with 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 1.2900 GBP/USD call.

The spot GBP/USD rate is the underlying market.

If the underlying is trading at 1.2730, for example, our call is out of the money.

Its intrinsic value is 0.

However, if GBP/USD is trading at 1.3050, our call option has an intrinsic value of 150 pips.

That's because if we exercised the option, we could buy GBP/USD at 1.2900, the exercise price of our call.

This would allow us to sell at the underlying price of 1.3050 for a profit of 150 pips.

Having run through these basics…

...let's now look at how we can use options as part of a Forex hedging strategy 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 if you bought the call, you have unlimited upside with a strictly limited downside.

This opens the door to a wealth of possibilities when it comes to your hedging Forex strategy.

Let's look at a simple example:

...buying an option as a protection against price shocks.

Let's say you are long AUD/USD.

You've taken the position to benefit from the positive interest rate differential between Australia and the US.

For example, if the long SWAP value is +0.17 pips, this means that:

…every day you are long the trade, you are gaining interest.

However, holding the position also exposes you to price risk.

If the currency pair moves sideways, or better rises, you are going to be fine.

But if its net movement is downward more than an average of 0.17 pips per day, you are going to make a loss.

Your real concern is a sharp drop, which could significantly outweigh any gains from the positive SWAP.

So how to mitigate this price risk?

One of the easier ways is to buy an AUD/USD put that is out of the money.

Because the option is out of the money, its premium will only consist of time value.

The further out of the money, the cheaper the premium you will have to pay for the put.

The risk profile of a put is that you have a fixed cost i.e. the premium you pay to buy the put.

But once you have paid this, it provides protection against sharp downward movements.

Let's work through some numbers.

Let's say you bought one lot of AUD/USD on 9 September when the price was 0.7600.

You took the long 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 downside.

You decide that the best way to hedge the risk is to buy an out of the money put option.

You buy the 0.7500 put with a one-month expiry at a price of 0.0061.

At expiry, the 0.7500 put will be worth something if the underlying has fallen below 0.7500.

By buying the put, you have reduced your maximum downside on your long trade to just 100 pips.

That's because the intrinsic value of your put starts increasing once the market drops below its exercise price.

Your overall downside is:

...the 100 pips between your long position and the exercise price, plus the cost of the put.

In other words, a total of 161 pips.

The diagram below shows the performance of the strategy against 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 long the underlying is a bit like a deductible of the insurance policy.

Want to know the best bit?

Your upside has no limit.

As long as AUD/USD keeps rising, you will keep making profit.

To continue our example:

...let's say AUD/USD plummets to 0.7325 at expiry.

You will have lost 275 pips on your long position.

But your put, the right to sell AUD/USD at 7500, must be worth 175 pips.

Therefore, you have lost only 100 pips.

Add in the 61 pip cost of the option's premium in the first place, and your total downside is 161 pips, as stated above.

No matter how far AUD/USD drops, this number never increases.

Now consider, AUD/USD rising to 7750 at expiry.

You make 150 pips on your long position, but your option costs 61 pips.

Overall, you make the difference, which is 89 pips of profit.

A final word on Forex hedging strategies and techniques

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, though, means they are better suited to traders with more advanced knowledge.

Options offer the versatility to set up a variety of hedging strategy Forex risk profiles.

This allows you to fully tailor your best Forex hedge strategy to properly suit your attitude to risk.

If you want to practise different Forex hedging strategies, trading on a demo account is a good solution.

Because you are only using virtual funds, there is no risk of an actual cash loss and you can discover how much risk suits you personally.