Currency markets show interesting trends this year, as the major currency pairs EUR/USD, EUR/GBP, and USD/JPY have developed long-term price trajectories. For conservative traders that are looking to limit risk, this has created the need for different types of hedging opportunities as a means for playing the broader price moves. It is important to remember that hedging your positions does not necessarily mean that it will be impossible to generate profits.
But in cases where markets are showing rising volatility levels, it is critical for investors to structure positions so that there is strong protection against adverse market moves that could ultimately render a trading account ineffective.
Certain trading periods are known for slowing volatility and reduced trading volumes. Typically, these scenarios unfold during the summer months and during extended holiday periods. But once these time periods come to a close, we will typically see forex prices that start to undergo new price trends.
As is usually the case, price movements are most forceful in the major currencies as these are the currencies that receive most of the actual trading volumes. In addition to the currency pairs listed above, this can also include forex instruments like the AUD, NZD, and CHF and all of these currencies have shown strong trend changes in recent months. So if you are an investor in any of these currencies, it is a good idea to have an understanding of the hedging strategies that can be used to protect gains that have been made with prior positions.
As an example, let’s look at the EUR/USD which is trading at long term highs just below 1.16. The bullish trends have been clear and strong for the last several months and if you have been long the forex pair since the rally started (near 1.12), it might be a good idea to lock-in those gains. Fortunately, this does not require you to actually close your position, as there are will often be very good reason to keep certain positions open and active (i.e. when those positions are accumulating carry trade value). But if you do want to hedge against potential losses later, you will need to open some sort of trade that opposes the direction of your current forex investment -- and two of the best ways of accomplishing this is through forward contracts and forex options.
When doing this, it is important to understand that both forward contracts and forex options can be used to express views in both directions: up and down, bullish and bearish. The key to these types of investing strategies is to construct an opposing viewpoint that will offset the intention of previous trades in equal ways. If there are any imbalances here, it will mean that your risk for loss is not totally removed. So these are all factors that must be considered when you are looking to gain protection in your forex trades in these types of scenarios.
A forward contract gives forex traders the ability to buy or sell a currency at a set price on a future date. Successful trading forward contracts requires traders to make price forecasts that are based on both price and time, so there are some differences here when developing strategies in forex spot markets. In these cases, traders are able to close positions at any time and this creates a different level of flexibility when you are using active strategies. There are strong advantages to using forward contracts, however, as they will enable you to command a price level that is different from what is currently seen in the market. In terms of hedging ability, this can help you to offset potential losses which can be seen in the market starts to work against your current active positions.
Forex options have some similarities with forward contracts in that there is a clear need to develop a forex strategy using factors of both price and time. Forex options will always involve an expiry time and a strike price that are used to structure positions and hedge against potential losses. There is a good deal of flexibility with respect to the number of time frames that can be used. There is also a number of different option types that will inevitably work best under certain types of forex market circumstances.
For example, a no touch option would actually involve two strike prices and there is a substantial payout if forex prices fail to touch either price zone. There are also one-touch options, which will require prices to reach a specific level (either to the upside or to the downside). If you are looking to establish a bullish stance on a given currency, you will want to use CALL options to express the view. In contract, a bearish position will generally involve the use of PUT options, which pay out if prices fall below their initial levels. When hedging, forex traders will often take a position in the opposite direction of a current spot price trade. So, for example, if you currently hold a long position in the EUR/USD, you would be able to hedge against potential losses by using a PUT option that will benefit from market moves to the downside. These two positions would balance out one another, and this would limit the potential for losses if markets do not move in the direction you initially anticipated.
Ultimately, it is important for forex traders to understand the different types of strategies that can move your trading beyond the traditional spot price investments. Using a demo account is a good way to get started with both forex options and forward contracts so that you can see how each method works. Payouts work differently with these instruments when compared to what most forex traders might be used to using and so it is best to have some practice and experience how real-time market moves can impact your position when you are looking to start forex hedging.