While most traders incorrectly believe that Forex hedging is going both long and short on the same currency pair at the same time, the term actually has a much broader meaning. The main purpose of hedging is to protect. In case of financial trading, the goal of hedging is to protect trader’s capital. As you can see, the goal here is not to make profit, but to limit losses, which sometime means a smaller guaranteed loss to prevent a bigger unpredictable loss. There are following ways to use the foreign exchange market in hedging:
You make money in a foreign currency. Even if you are not a Forex trader, you may use the currency market to hedge your risks connected with depreciation of the currency you make your living in. For example, if you earn British pounds but spend US dollars, you can use short GPB/USD position to mitigate any loss of value of your expected paycheck.
You plan a significant expenditure in a foreign currency. When the time comes to spend a big amount of money in a currency different from your own, you may stumble on an unexpectedly high currency rate difference. A spot Forex transaction can protect you in this case. For example, if you plan to buy a house in Europe, while your savings are in the US dollar, you can use a long EUR/USD position to hedge such risks.
Foreign equities and bonds (especially bonds). Another noteworthy case is when you are planning to invest into some foreign equity market or buy some foreign bonds. Even if you manage to make profit from such an investment in foreign currency, you may end up with a loss when you convert back to your own currency. This is particularly common with the emerging markets, where currency volatility can be extremely high.
In all those cases, calculating position size necessary to hedge your currency risk is trivial. All you need to know is the amount of money you are hedging denominated in the base currency of the pair you are using for hedging (XXX of the XXX/YYY currency pair) and the lot size for the same currency pair used by your broker (usually, it is 100,000 for majority of FX pairs). The following formula should be used:
For example, if you are going to earn ¥500,000 and the current USD/JPY rate is 100.00, you expect to receive $5,000. If the rate jumps up to 125.00, you will end up with only $4,000. So you need to hedge yourself by opening a long USD/JPY position that would earn you those $1,000. The size of that position would be:
At the same time, you have to remember that hedging has its downside — you lose the opportunity to save or even make money on favorable currency rate changes. When deciding whether to use currency hedging, you always have to consider the potential risk you are ready to take without hedging and the potential advantage you will miss without it.
I personally, use hedging very rarely, in part due to the fact that brokers usually lack of the currency pairs I need. Yet sometimes, I open spot FX positions purely for hedging purpose. And how about you?
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