Forex Hedging: An Introduction

What is Forex Hedging?

A business man wielding an holographic lock symbolizing security.

Think of a hedge as a protection on your trade. Hedging is a way to lessen the amount of loss that you may experience if something unexpected happens.

Forex hedging, also known as a foreign exchange hedging, is a method used by a wide range of market participants including investors, traders and businesses to eliminate or “hedge” their foreign exchange risk resulting from transactions in foreign currencies.

Furthermore, most hedges are meant to eliminate a part of the exposure risk instead of all of it, as there are prices to hedging that can outbalance the gains beyond certain times.

Simply put, hedging is a trading strategy that aims to protect one’s position from any adverse or abrupt movement in a currency pair.

See Also: How to Avoid Losing Money in Forex Trading

Why Hedge Forex?

One of the main reasons why you would want to carry out a forex hedging strategy is to limit risk. There is also a benefit of utilizing a hedging strategy to help you reduce the loss to a known amount. A trader may choose to hedge forex as a way of protecting their trade against exchange rate fluctuations.

Hedging can become a major part of your trading approach once done in a vigilant manner.

However, there is no certain method to eliminate risk completely.

There are, of course, dangers to forex hedging which is why it should only be used by experienced traders, or else playing with it using a wrong method could prove to be disastrous to a trader’s account.

Using a Forex Hedge

The primary ways of hedging currency trades are spot contracts, foreign currency options, and currency futures.  

Spot Contracts

A spot contract – also called spot transaction or simply spot – is a contract of buying or selling a commodity, security, or currency for instant settlement on the spot date which is usually two business days after the trade date. Spot contracts are not the most effective when conducting hedging which is why most of the time a hedge is needed due to regular spot contracts.

Foreign Currency Options

Foreign currency options, on the other hand, provide owners the right, but not the responsibilities, to purchase or sell a currency at a certain cost. These instruments utilize hedge to oppose the chance of losses due to the changes in the exchange rates.

Currency Futures

The currency future – FX future or a foreign exchange future – is a futures contract to exchange one currency to another at a particular date in the future at an exchange rate which is fixed on the buy date.

Not all retail forex brokers allow for hedging within their platforms. Be sure to research the broker you use before beginning to trade.

Bear in mind that not all retail forex brokers permit hedging within their trading platforms so make sure to conduct your own research, if you wish to perform forex hedging, regarding which broker to choose before opening a trade account with them.

Example of a Forex Hedge

Let’s say for instance a US investment bank has a set schedule of reclaiming a number of profits earned overseas, it could rely on hedging of some of the expected profits using an option. As the scheduled transaction would mean selling euro and buying US dollars, this investment bank should buy a put option when selling euro. Buying the put option means the company would be held in a worst-case scenario rate for its future transaction – the strike price. If the currency exceeds the strike price at expiry, the company, then, would not utilize the option and should now do the transaction in the open market. The cost of the hedge is the cost of the put option.

Advantages of Forex Hedge

There are advantages of using hedges when it comes to trading. For instance, you certainly could close your primary trade and then enter the market at a better price. You can also keep your trade on the market and earn money with a second trade that makes more gains as the market moves in opposition to your first position.

Also, the best part about hedging is that when you begin to doubt the market and you feel like it’s going to reverse to favor your initial trade, you can set a stop to the hedging trade, or simply close it.

Three Forex Hedging Strategies

A person trading on the forex market through a laptop.

Simple Forex hedging strategy

This strategy, firstly, involves opening at the contrasting position to a recent trade. For example, if you have a long position on a currency pair, you may opt to open a short position on the same currency pair. This is also known as a direct hedge.

However, the net profit of a direct hedge amounts to zero, despite that, you would be able to keep your original position. This is extremely advantageous when the market begins a reversal trend. Without the hedge, closing the trade, consequently, means accepting losses. On the flip side, if you decided to hedge, it would allow you to earn profits on your second trade, therefore, gaining back what you have lost on your initial position.

Multiple currencies hedging strategy

Similarly, a forex trader can make a hedge that opposes a specific currency by using two different currency pairs that are positively correlated, such as GBP/USD and EUR/USD, and then taking positions on both pairs, however, in the different direction.

For example, let’s say you decided to take a short position on EUR/USD and then proceeded to hedge by opening a long position on GBP/USD. If the euro dropped against the dollar, you will take a loss on your GBP/USD position, but it would be offset by your EUR/USD position.

Forex options hedging strategy

At last, Forex options or currency options offer owners the right, but not the responsibilities, to exchange them for a particular price in the future. Forex options are the most popular hedging tools because they give you the freedom to reduce your exposure while only paying the price of the option.

Final Thought

In conclusion, always remember that hedging is often a complex method and needs a lot of preparation. The most important reason why you would want to use hedging on your trade is to limit the risk that you might experience.

Finally, if you use hedging wisely on your trade, it can give you a better trading plan. However, hedging should only be used by expert traders who understand the market swings and timing. Even more, using hedging without enough experience could be harmful to your account and it might ruin it in the long run.

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