Trading international currencies can be an incredibly profitable endeavor. In fact, on a single day, more than $5 trillion worth of currency is traded and exchanged around the world. If you are able to invest in a single currency before it increases in spending power, your wealth can significantly increase.
However, as you will soon find with any type of speculative trading, trading international currencies does not come without its fair share of risks. Whenever a currency is increasing in relative value, that means others will be decreasing in value of response. If you are stuck holding the wrong currency as a major event unfolds, you’ll end up losing money.
There are plenty of events that can cause exchange rates to quickly change. Announcements from central banks, ongoing political activities, and changing global markets will all have an impact on international currency values.
In order to protect themselves from the risks of fluctuating exchange rates, traders will typically hedge their portfolios. Hedging is especially important when the national currency is actively changing in value, something that Americans (USD) have seen for much of 2019. In this article, we will discuss the most important things for you to know about hedging and how these techniques can improve your overall currency hedging strategy.
What is exchange rate risk?
As you might risk, exchange rate risk is the risk of losing wealth due to changes in a currency’s spending power. If your wealth is entirely held in dollars, for example, you are necessarily holding onto asset-specific risk. In the event that it suddenly takes more dollars to “purchase” Euros or Pounds (GBP), the value of the dollar will have depreciated.
Exchange rate risk is highest when a nation’s currency is moving in a bearish direction. When Zimbabwe experienced its recent bout of hyperinflation (as high as 89.7 sextillion percent in 2008), the exchange rate risk attached to the Zimbabwe Dollar was incredibly high. While the world’s top forex currencies—USD, EUR, GBP, JPY, NZD, CAD, AUD, CAF, etc.—experience much lower rates of inflation, even minor dips in spending power should not be ignored.
The term “hedging” is used to describe various strategies used to limit the risk of holding onto a single currency. The most obvious form of hedging is diversification. The value of one currency directly influences the value of another. For example, if the United States were to announce a series of steel tariffs, the dollar would experience a minor drop in spending power. When all else is equal, currencies of other steel-producing nations (such as Japan) will become more competitive and increase in value.
In order to avoid instances like these—a real-world example occurring in 2018—you can hedge your holdings and invest in multiple different currencies.
Know when (and how) to hedge your portfolio
Some investors prefer to keep their portfolios hedged throughout the entire year. This is a form of passive investment; these traders assume they cannot outsmart the market and instead diversify in order to reduce the risks of trading.
Passive investing is a very safe approach to the world of forex, though many traders believe it is unnecessarily conservative. Instead, it is generally better to invest heavily in your national currency when markets are bullish and only hedge your portfolio when markets are trending in a bearish direction.
Following the announcement of Brexit in 2016, traders everywhere knew that the spending power of the pound was about to decrease (due to decreased free trade). Over the course of the next six months, the Pound went from being worth $1.45 to $1.21.
In order to avoid this major drop, pound-heavy investors needed to hedge their positions and allocate their wealth elsewhere. Knowing the right time to hedge requires both technical and fundamental analysis. In addition to paying close attention to the news (and making adjustments in response), you should also monitor technical indicators such as moving averages, relative strength, changing pivot points, and others.
Using Forwards and Futures Contracts
If you want to keep your wealth attached to a specific currency (such as your national currency), currency forwards may be one of the most helpful tools available. Currency forward contracts make it possible to eventually cash out bonds at a predetermined rate (the forward rate). These contracts make it much easier to predict your future ROI.
The primary drawback of using currency forwards is that you may end up missing out on unpredicted currency upswings. These contracts should be viewed more as an insurance policy, used to protect against the uncertainties of the future.
Currency futures contracts are similar to currency futures contracts, though they are notably less customizable. Each futures contract gives you the obligation to make a currency exchange at a specific rate at a specific point in time. If exchange rates change as you predicted, the contracts can significantly increase in value. But while they can help hedge your risks, they should not be considered “risk free.”
Additionally, currency options contracts give you the right to exchange at a certain rate, but not the obligation. Simultaneously purchasing options above and below current prices (spot price) can help you control the range of risk you are assuming. Options contracts can purchased in most other speculative markets as well.
Investing in Already Hedged Assets
Instead of going through all of these steps and hedging your risks “the old fashioned way”, you may want to consider directly investing in already hedged portfolios. Within the forex market, for example, there are multiple already hedged exchange traded funds (ETFs).
ETFs allow you to hold a stake in multiple different currencies at once. In exchange for a small fee, you will gain access to a highly diversified portfolio. ETFs contain elements of both passive and active trading strategies. This makes it possible to control the exact level of risk you are currently holding onto.
It is also important to remember that the strategies mentioned in this article are not mutually exclusive. In fact, the best hedged forex trading strategies will likely involve a mix of fundamental analysis, futures contracts, and ETFs. By taking multiple steps to reduce the risk of holding a single currency, your risk-reward ratio will directly improve.
Becoming a successful trader is all about carefully balancing the pursuit of returns with the avoidance of risk. Before you get too excited about trading foreign currencies, be sure to hedge yourself against the risk of the future unknown. These strategies can all help you get pointed in the right direction.