Trading Tips

Hedging One Forex Pair with Another

The hedging topic often comes up in forex forums. One recent example was a trader who likes to trade GBP/JPY in what is basically a carry strategy. In order to protect his downside, he hedges his position with a short in CHF/JPY. The two are fairly highly correlated, so that would seem to be a good hedge. In theory, it is. There’s a bit of a snag in it all, though.

Firstly, when you hedge you need to match position values. Since a lot of GBP/JPY has a higher value than CHF/JPY – remember you are buying or selling the first (base) currency – you need to actually sell more than a single lot of  CHF/JPY to accomplish a full value hedge.  The GBP/CHF exchange rate is currently about 2.3, meaning you would need to sell about 2.3 lots of CHF/JPY for each GBP/JPY you go long.

Here’s the catch, though. If you do that full value hedge, you actually end up creating a completely different exposure in your account. When you match a long GBP/JPY with an equal value of CHF/JPY you end up completely cancelling out your JPY exposure by going long and short equal amounts of that currency. That leaves you with a long GBP/CHF position, which obviously has completely different price action characteristics.

Of course you could then short GBP/CHF to totally nullify your risk all together. There’s not much point of that, though. In doing so you would lose your ability to gain on any type of price movement, would end up with a net loss because of the spread doing all those trades, and would probably be in a negative carry position (or at best neutral).

This is why it’s important to understand the implications to your net overall exposure when you trade multiple forex pairs, for hedging or otherwise.

By John

Author of The Essentials of Trading