How to hedge using FOREX
New to the word hedge? Oops that’s a big problem. Just Kidding!!! Learning is a continuous process and especially when it comes to trading, continuous learning helps a trader trade while being stress free. Let’s first understand hedging. Hedging an investment is a way of attempting to insure against a negative event happening.
Risk of a loss is frightening. Isn’t it? Whether it be a business owner or an individual who is selfemployed, everyone is worried about the losses. Hedging is nothing but coming up with a way to protect yourself against that risk of a loss in future. In trading, future price movements are unpredictable and hedge keeps a trader prepared against the risk due to uncertainty. As a trader, predicting future price movements can be done through analysis. And this is where risk management comes into picture. One thing which has to be made clear is that trader’s job is not to predict, but to trade. Obviously trader is the one who trades. This means a trader can’t sit with the hope that a trade will work out, managing risk is an important aspect.
That said, let’s get back to hedging. To understand the concept, we will go through an example. An individual purchases a car insurance, will that prevent them from being in an accident? NO it won’t. It simply reduces the negative impact, i.e. the loss of money due to an accident. Now in trading terms, let’s say you own ABC fund and you expect the value of this fund to go up in future. In order to hedge against the risk of ABC going down in value you take up another investment say PQR fund which is negatively correlated to ABC which means, when ABC goes up, PQR goes down and vice versa. In other words you buy and the rate went down. How would you hedge to reduce the loss? You would hedge with an equivalent sell order and you minimize the losses since each pip movement cancels out. So in this way you are insured in case things go against the trade you make.
Now, since we understand the concept of hedging, there are three more terms which we need to quickly grasp before we proceed. We need to know what it means to take a position in a market and then what is long and short position. When a trader enters into a trade, taking a position means a commitment to buy or sell currencies, or any other trading security for a given price. And you thought it was going and sitting in the market place? Oh yes, it’s almost the same but you are not literally going and sitting there. Taking a long position refers to buying a currency pair and when you are selling a currency pair you are taking a short position.
So far so good. When does a trader enter into a forex hedge? When a currency trader enters into a trade with the intention of protecting an existing position from unexpected movements in the foreign exchange rates, he can be said to have entered a forex hedge. Using the Forex hedge appropriately a trader who is going long can protect against downside risk, while a trader taking a short position can protect himself against the upside risk.
In today’s market forex hedging is achieved through various types of hedging contracts. Here is a summary of some of the foreign currency hedging tools:
- Spot Contracts – Buying or selling a foreign currency contract at the current rate, requiring settlement within 2 days. Due to the short term settlement they are not very commonly used for FX hedging. But they are used in combination with other types of hedging tools when implementing a hedging strategy.
- Option Contracts – A foreign currency contract giving the buyer the right, but not the obligation to buy or sell the foreign currency contract at a specific price (strike price) on or before the expiration date. In order to buy this option, the amount which the buyer pays to the seller is called the option “premium”. A foreign currency option contract can be used as a hedge for an open position in the spot market. When the expiry date arrives, they trader (buyer of the option) can exercise (buy/sell the underlying currency pair) option if the price movements have been profitable for him. If the price movements were such that exercising the option is not worth, it expires.
You want to buy a house priced at $150,000. And you don’t have money. However you feel you could somehow arrange the amount in one month time. Hence, you arrange a deal with the seller to hold the house for you for a period of one month in return for a holding fee of $3,000. At the end of one month you have the following options:
- Pay the $150,000 and buy the house OR o You realize that the house is not worth the money and you don’t want to buy it anymore. So you walk away from the deal OR
- The price of the house is now $180,000 and you try to make profit out of the right to buy option you have, i.e. you sell your right to buy the house to someone who desperately wants the house and in return make a profit of $30,000
This is called Call Option. The right to buy the underlying asset (which will be the currency pair in case of FOREX) at the specified price (strike price) on or before the expiration date for a price (the premium). In this example $3,000 is the premium paid.
- Forwards – A forward contract is an agreement to buy or sell a currency at a fixed price on a certain date. Foreign currency forward contracts are considered over the counter due to the fact that there is no centralized market place and transactions are conducted directly between parties.
- Swaps – As the word suggests swap refers to an agreement to swap or exchange equal amounts (called principal amounts) of two different currencies at the spot rate. Then the buyer and seller exchange interest rate payments over the period of the contract. Though the principals exchanged are equivalent amounts, the swapped interest rate payments are usually not the same.
Let’s look at an example. And you definitely need one. Isn’t that correct. Here you go.
Consider a trader A, who requires sterling (£) and trader B who requires USD ($). A gets into a swap with B, receives 10£ and pays 7% fixed interest rate in sterling, i.e. Interest amount = 7% of 10£. Similarly since B requires USD, it goes into a swap with A and pays an interest of 4% on say 10$.
Assume this is a three year currency swap and entered on Dec 1, 2015. Interest payments are once a year and the principals are 10£ and 10$.
Nothing comes for free in this world and so is Forex Hedge. There is a cost involved with implementing a foreign currency hedge whether it be in the form of option premium, margin or hedging profit and loss. But if you consider the protection which a forex hedge can provide, the cost to apply the hedge is relatively smaller. Foreign currency hedging is a valuable foreign currency risk management tool. But on the other hand if the hedging is not properly implemented, it can be very dreadful. Consider learning the trading strategies well before implementing them.