Forex Hedging is a technique that involves trying to protect a currency pair’s position in the event of losses. The main idea of Hedging is to hold two or more positions at the same time. If the losses occur in one position, a trader can counter these losses from the gains of other positions. However, some traders believe that hedging strategies just temporarily hide losses.
What is a Forex Hedging Strategy?
Most people recognize the phrase, “hedge your bets.” This means protecting oneself against loss by supporting more than one possible outcome.
In the forex market, Hedging is short-term protection from uncertain moves. News and events are the reason for this uncertainty. To save himself/herself, a trader seeks refugees in the Hedging strategy.
In the book, Hedging: principles, practices, and strategies for the financial markets, author Joseph D. Koziol described Hedging in financial markets in details.
Two of the most popular strategies he mentioned were; one to set the hedge by taking the opposite position for the same currency pair, and second, was to buy forex options.
Let’s find out more about these strategies.
First Hedging Strategy
A trader can place a hedge on an existing currency pair position to secure his/her winners by holding another short or long position of the same currency pair.
This strategy is known as the “perfect hedge strategy” as it eliminates the potential risk associated with losing trade.
Traders apply this strategy in long-term trading. By creating a hedge, they save their long and short positions, if the market goes south.
Suppose a trader is holding a long position for EUR/USD. They bought the pair for 1.245, and now the price level is at 1.251. They find out that a particular event can disrupt the position of EUR/USD. They place a hedge of EUR/USD at 1.251. If the market moves below 1.251, they still profit from the gains of the first position.
Second Hedging Strategy
The second hedging strategy is known as the “imperfect strategy,” uses the forex options to safeguard the existing currency pair by creating a temporary hedge.
In forex options, a trader can select the prices and expiration of a currency pair. That’s the reason why this strategy works with Hedging.
The strategy is called imperfect, as it reduces some of the risks and not all of them.
In this strategy, a trader who is going long needs to sell put options to limit the downside risk. Whereas, a trader going short needs to buy call options to reduce an upside risk.
1. Downside risk hedge strategy
Using a put option, a trader can sell a currency pair at a specific price after a certain date. Therefore, a trader places a hedge, so a currency pair doesn’t fall below the specified level.
Let’s say a trader is holding EUR/USD’s long position at 1.245. They want the price to go higher, but are concerned that the market can go bearish due to the economic event coming this week. They place a hedge somewhere below the current price, i.e., 1.241, and set the expiration date after the economic event. If the price goes below 1.241, a trader loss is 1.245 – 1.241 = 0.004, which is 4 pips.
2. Upside risk hedge strategy
A trader can use call options to buy a currency pair at a specific rate before the expiration date.
Suppose a trader is holding a short position of USD/CAD at 1.345. A trader is cautious that the price can go bullish after the U.S. presidential election. So, they buy a call option and places a hedge above the current price at 1.349. Also, they set the expiration date before the elections. If the price goes above 1.349, they risk only 4 pips i.e., 1.349 1.345 = 0.0004.
Forex Hedging Strategy Conclusion
By taking different positions, a forex hedging strategy attempts to lower the potential risks involved. However, many believe that hedging strategies are just a way to hide losses. I would personally prefer to conduct detailed market analysis to anticipate which direction I beleive the market will move rather than try to catch it both ways. That being said, hedging strategies are often used by professional funds to try and offset risk.
Becoming a successful forex trader can take many years of practice. It is not easy to make a living from forex trading in my opinion. It will require immense trading discipline, good money management, and a bullet proof trading plan.
Furthermore, I would combine multiple technical analysis, fundamental analysis, price action analysis and sentiment analysis to filter all forex trading signals whatever forex strategy I was using.
The methods of trading forex that are outlined within this article are just ideas. You should trade forex in a way that suits your own individual style, needs and goals.
If you would like to practice forex trading online, you can open an account with a forex broker and download a trading platform completely free of charge. If you are looking for a forex broker, you may wish to view my best forex brokers for some inspiration.