The exchange rate of a domestic currency against another currency is usually a floating rate, unless it’s a country like China, which has a fixed exchange rate system. For most major economies, currency rates fluctuate due to demand and supply for domestic currencies, interest rate differentials, economic growth, inflation reports, geo-political developments and other factors. Also, the nature of the forex market, which is decentralised and completely online, influences rates. Trading occurs at tremendous daily volumes, at dizzying speeds globally.
These fluctuations cause exchange rate risk or currency risk for people dealing with currency transactions, such as forex traders, corporate houses, travellers and other investors. Negative forex risk exposure can have huge effects on a trader’s bottom line, eroding profit margins.
There are various ways to reduce currency risks. Here are 5 basic ones that are popular among forex traders.
1. Assessing Currency Fundamentals
Traders prefer to invest in currencies that show strong performance. For this, they keep track of monetary policies and other economic indicators, like inflation rate, GDP growth, manufacturing index and unemployment rate of the countries involved. Countries with high interest rates tend to have high exchange rates. A sound economy also supports the domestic currency, preventing sudden volatility in its price movements. In addition, political developments also impact currency rates.
Exchange rates also tend to fluctuate more and re-adjust immediately before, during and after the release of key economic reports. If the market expects a country’s economic report to be dismal, the domestic currency could depreciate due to intense sell-offs. Traders need to cover their positions accordingly, before the release of any economic data. Having an economic calendar can help them stay updated on such releases.
There are also some currency pairs that are considered “majors.” These pairs belong to highly developed and industrialised economies, and are traded in large volumes, such as the US Dollar, Euro and Pound Sterling. So, traders tend to find high liquidity and ample volatility when trading these currencies. Currencies like the Swiss Franc are considered safe-haven assets, which investors flock to when the global economy is in distress. The Swiss Franc is supported by the country’s neutral political stance and low debt-to-GDP ratio.
2. Improved Market Forecasting
Fundamental analysis, coupled with efficient technical analysis, can help with informed market forecasting. Through various tools and indicators, the price action of currencies can be predicted and strategies formed. For instance, currency prices can break through key support and resistance lines after market moving news events. Breakout traders take advantage of these moves to plan their positions.
Technical analysis is a vast subject in forex trading, but to sum it up, traders usually:
- Identify key support and resistance levels
- Use trend indicators, like moving averages and trend lines, to identify trends and judge their strength
- Predict reversal of trends
- Identify chart patterns and what they mean
- Analyse increasing and decreasing trade volumes in a particular currency pair.
3. Deploying Risk Management Tools on the Platform
Trading platforms like MT4 and MT5 are equipped with various orders to help manage downside risks. Tools like stop orders and trailing stops can protect profits and close positions when sudden and unforeseen price fluctuations occur.
Stop loss helps to close out positions when the market moves in an unfavourable direction, cutting losses short. These orders are executed at the best available market price, based on available liquidity. Limit orders allow traders greater flexibility to define the entry and exit points of a trade. Orders here are executed only when specific price levels are met.
Trailing stops, on the other hand, are based on a predefined number of pips away from the market price. This order automatically trails the position, if the market moves according to the trader’s objective. Using the take profit order, traders can close a position automatically when the price reaches a defined level. This allows traders to lock-in their gains, despite market volatility.
4. Hedging Strategies
Currency hedging is a strategy used by traders to minimise the impact of currency risk on returns. This is the process of buying or selling currency pairs to offset current positions and reduce risk of exposure. A simple hedging strategy could be a direct hedge, where traders open the opposing position of a current trade. This means a trader opens long and short positions on the same currency pair, simultaneously. The net profit here might be zero, but the original position stays intact in the market, ready for a trend reversal.
Many traders also hedge by using multiple currencies. The correlation factors of these currencies have to be looked at first. A positive correlation means two currency pairs move together, while a negative correlation means that they move in opposite directions. For instance, the EUR/USD is often found to be positively correlated with the GBP/USD, as Britain and Europe have close economic ties and geographical proximity.
So, a trader might consider going long on the GBP/USD and hedge their exposure to the US Dollar by opening a short position on the EUR/USD.
5. Using Forex CFDs
Forex derivatives like Contracts for Difference (CFDs) are highly versatile instruments that allow traders to hedge currency risk. CFDs allow traders to exchange the difference in price of a currency pair, from the date of opening a position till that contract is executed on the closing date. CFDs can be used to counter currency risks, since they allow traders to trade in both rising and falling markets.
If a trader enters a long position on the EUR/USD at a certain date and expects the Euro to decline in value in the near future, they can simply add additional positions, instead of selling at a loss. These positions can balance out the initial position. So, here the trader can open a short position using a CFD, which will offset the losses from the CFD long position in EUR/USD.
Managing currency risks also includes having access to a trading platform that enables fast execution speeds, so that negative slippages can be avoided. Managing leverage and position sizes are also essential to minimise risks. Huge position sizes and leverage ratios in illiquid currency pairs, like exotics and minors, can entail high risk.