Hedging Currency Risks with Online Forex Trading

No, this guide isn't about profiting from Forex by using "hedging" (grid) strategies. Despite the fact that many traders still prefer trading without a stop-loss, there is rarely a sound reason to do that in Forex. However, there is at least one case when trading without a stop-loss is very important — hedging.

Hedging foreign currency income with a Forex trade

Forex market isn't just a good place to make money, it's also a perfect financial instrument to hedge your currency risks if you are earning income in a foreign currency.

For example, you live in Germany but earn your salary in US dollars. This situation makes your income very vulnerable to EUR/USD fluctuations — a rise from 1.2000 to 1.4000 would mean a drop in the euro-value of your income by 14.3%, while a drop from 1.2000 to 1.1000 would mean a rise of your actual euro income by 9.1%. Your dollar savings would also be affected by the change in EUR/USD rate (unless, of course, you aren't going to spend them in United States).

Many foreign contractors, transnational businessmen, and outsource workers often get themselves into situations similar to the one above. Some people don't do anything about that, others try to wait for some "best" rate to exchange their earnings. But there's a better solution for all those people — Forex hedging. Actually, it's quite easy to hedge your currency risk with any retail Forex broker. All you have to do is to open an account, make a deposit, and long (buy) the currency pair X/Y, where X is the currency you spend in (the euro or EUR in the above example), and Y is the currency you earn in (the dollar or USD in the above example) or short (sell) the currency pair Y/X.

So, if someone is earning dollars and spending euro, they should be long on EUR/USD. This way, if euro rises against the greenback, the purchasing power of the person's usual earnings will still go down, but it will be compensated by the profit from their long EUR/USD position with the Forex broker. In the opposite case, if euro declines against the USD, the purchasing power of the earnings will rise, but there will be a loss in Forex trading at the same time. Of course, one shouldn't use any stop-loss or take-profit orders in hedging.

Let's get to a more detailed example with a resident of Japan getting their income in US dollars. Their expected monthly income is $10,000. The current USD/JPY rate is 83.00. That means that their income converted to yen is ¥830,000 at this moment. They don't want lose if the USD/JPY rate decreases. That's why they open a short USD/JPY position with a size of 0.1 standard lot (1 mini-lot). 1 pip of a mini-lot position in USD/JPY equals ¥100 exactly. So, if by the end of the month (when the person receives their $10,000 payment), USD/JPY drops to 82.00, they lose nothing, because their 100-pip profit (or ¥10,000) fully compensates the drop in the yen value of the payment from ¥830,000 to ¥820,000. If USD/JPY goes up to 84.00 the gain in purchasing power of $10,000 (from ¥830,000 to ¥840,000) will be zeroed by the Forex loss of 100 pips (the same ¥10,000).

There is no need to close such a position at the end of the month — it can remain open indefinitely or until the monthly payment amount that needs hedging changes. If the payment amount changes, the position size should be adjusted proportionally.

Hedging 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 encounter 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.

Hedging the risks associated with foreign equities and bonds

Another noteworthy case is when you are planning to invest into some foreign equity market or to buy some foreign bonds. Even if you manage to make profit from such an investment in the 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.

Formula for hedging currency risks

In all those cases, calculating the 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 the majority of FX pairs). The following formula should be used:

HedgingPositionSize = frac{text{Amount in XXX}}{text{Lotsize of XXX/YYY}}

For example, if your own currency is USD, you are working in Japan, and you are going to earn ¥500,000 JPY, while the current USD/JPY rate is 100.00, your expected income in your own currency is $5,000 USD. If the rate jumps up to 125.00, you will end up with only $4,000 USD. 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:

HedgingPositionSize = frac{5,000text{ USD}}{100,000text{ USD}} = 0.05text{ lot}

It should be obvious that neither stop-loss nor take-profit are required in this hedging set-up — the aim here is not to earn money from Forex trading, but to prevent any loss from your income currency depreciation. This strategy can be carried out with any leverage, but the very low leverage or no leverage at all is recommended because you don't want to get a margin call on your hedging position. As always, your Forex broker should be reliable and support prompt withdrawals for this strategy to work effectively.

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 changes of the currency rate. 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.

If you have any questions, comments, or opinion regarding the use of online Forex trading for currency risk hedging, please feel free to join our Forex forum.


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