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Hedging multiple currencies


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The pair correlation statistically shows how the currencies have behaved over a period of time. Mainly, whether they have moved in opposite directions, in the same direction, or randomly.

In this case, correlation coefficients are used as a measurement technique to determine the strength of the relationship between two fluctuating currencies. This is displayed as a decimal number from -1 to 1.

Here is an example of what a correlation would look like in forex hedging:

  •     Positive Correlation: assuming the correlation is 1, this shows that both currency pairs will move in exactly the same direction most of the time. Some positive correlation pairs include AUD / USD, EUR / USD, GBP / USD and NZD / USD. In our example, we will use AUD / USD and EUR / USD. Simply put, if AUD / USD trades up, EUR / USD will follow the same path.
  •     Negative correlation: On the other hand, let's use USD / CHF and USD / CAD. In this example, a correlation of -1 would illustrate that USD / CHF and USD / CAD will move in opposite directions most of the time. Some examples of negative correlation currency pairs are USD / JPY, USD / CAD and USD / CHF. As you can see, the USD is the base currency.

Imagine you were short GBP / USD and then opened a long position in EUR / USD to hedge your USD exposure. If the pound was falling against the US dollar, then this long position on EUR / USD would make a loss. However, this would be mitigated by gains on your GBP / USD position. If the USD falls at that time, losses on this short position would essentially be offset by your hedge.

Hedging multiple currency pairs should not be done lightly as there are risks involved. In our example, we hedged our exposure to USD, but in return we also exposed ourselves to short exposure to EUR and long exposure to GBP in The thing is, there are no guarantees to any trading strategy. If you successfully reduce your risk in this way, you may see profits.

The main contrast between "direct hedging" and "multi-currency hedging" mentioned above is that with multi-currency hedging, a single position may see more profits than the other losses. With direct hedging, the net result would rarely exceed zero.

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Option hedging

A forex option allows you to trade an FX pair at a set price before a predefined time has elapsed. When it comes to hedging instruments, options are really useful. The reason is that they give you the opportunity to reduce your risk, and you only have to pay for the option "premium" itself.

Here is an example of a hedging strategy for forex options:

  •     You have a buy order on GBP / USD at a price of 1.32
  •     However, you prevent a sudden drop from occurring
  •     For this reason, you decide to hedge your risk with a put option at 1.32 that expires after 1 month.

In our example above, if the price has fallen below 1.32 by the time the expiration date arrives, your long position will record losses, but your option will make profits and offset this risk.

If the price of GBP / USD was higher than 1.32, you would only have to pay the price of the put option (premium).

It is really important to note that not all broker platforms offer options to traders. So if you are interested in it, you need to make sure that the platform allows you to trade this way.

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