What is Hedging in Forex?

The Forex market, even more than any other financial market, is prone to volatility and constant price fluctuations. Because of this, traders have to always stay vigilant and act quickly if the market moves against them. But even if there are no opportunities to save your trades, there's still a way to protect yourself from these unexpected price movements. This strategy is called hedging, and in this article, you'll learn what hedging is, how it works, and how you can apply it to your Forex trades.

What is Forex hedging?

Hedging refers to the act of buying or selling securities as a way to protect one's funds in case other open positions end up losing because of potential price fluctuations. Hedging in Forex (or currency hedging) involves opening new currency trades, often in the opposite direction of one's existing positions. This way, if the market volatility causes the price to change the trajectory of its movement, the profits from the hedged positions should make up for any losses incurred because of the initial trade.

Forex hedging is a very popular risk management strategy and is used not only by retail Forex traders and investors but also by large companies that have to conduct business in a different currency. If the exchange rate moves against them, they risk having to bear additional costs for converting their funds. Hedging helps to eliminate these costs or at least keep them as limited as possible.

How a Forex hedge works

Hedging is something you do when you want to protect yourself from adverse events. You can think of it as an insurance policy for traders. If such an event occurs and your initial trade goes sideways, a hedge is supposed to mitigate the impact of the event and save your funds from being lost.

However, hedging doesn't actually prevent losses from occurring. You still experience unsuccessful trades and even lose money as a result. But since hedging involves opening another trade that is supposed to perform well after a new market move, the profit from this hedge trade outweighs the loss from the initial trade.

In the end, you either end up with a small overall profit or with no profit at all, which is infinitely better than losing a large portion of your funds in one unsuccessful trade. Still, you should remember that hedging doesn't come for free if you're going to implement it as your risk management strategy.

Advantages and disadvantages of hedging in Forex

Like any other risk management strategy, hedging in Forex has certain advantages and disadvantages, so it's important to consider them before deciding to use hedging in your trading.

Pros of hedging in Forex trading

• Reducing potential losses. The key advantage of using hedging strategies in forex trading is the reduction of potential losses. Opening extra positions that oppose the initial trade can help you negate losses from one position with profits earned from the other. By doing this, you can mitigate or even fully avoid the adverse impact of sudden price fluctuations or unexpected market events, which can harm your prospects of closing a winning trade.
• Protecting profit. Hedging can also help you protect the profit that you have already earned. If you have an open position that has already made a significant profit, you might want to protect it from getting wiped out by a sudden spike in market volatility. In this case, opening a hedging position would protect the money that has already been earned in the initial trade and ensure you keep the profit that you've managed to make by this point in time.
• Limiting risks. Another thing you can use hedging for is limiting risks in volatile markets. If you're planning a trade for a currency pair and want to minimize the risks of losing money in case the market moves unexpectedly, you can open a hedge trade to protect yourself and limit your exposure to price fluctuations. Knowing that you have this risk management strategy involved can also alleviate some stress and help you make better decisions.

Cons of hedging in Forex trading

• Reducing the amount of potential profit. Hedging can protect your profit, but it can also reduce your winnings. That's because when you hedge, you basically open two trades that contradict and cancel each other out. This can lead to you getting significantly less (if any) profit than you would if you hadn't opened a hedge trade.
• Accumulating transaction costs. Since hedging involves opening multiple separate trading positions, it means you'll have to pay transaction costs for each of them. And while hedging can protect you from losses, the transaction costs can add up and eat into your profits.
• Missing out on market opportunities. When you open a hedge trade, you limit your exposure to the market. So if the market actually ends up moving in your favor, you won't be able to use this opportunity to increase your profit.

Best Forex hedging strategies

Simple Forex hedging

This is the most simple and straightforward hedging strategy, and it involves opening a second position—a hedge trade—in the opposite direction of the initial trade. The purpose of the hedge trade is to neutralize any losses that may come from the initial trade if the market changes the direction of its movement. For example, if you buy EURUSD at 1.1000 and the price starts to decline instead of increasing, you can open a hedge trade to sell the pair at 1.0990 to make up for incurred losses.

Multiple currency pairs hedging

This strategy involves opening several trades for different currency pairs that are correlated with each other. If the pairs are positively correlated (like EURUSD and GBPUSD), their value moves in the same direction. However, if they are negatively correlated (like EURUSD and USDCHF), and the value of one of them falls, the value of the other one will rise.

This can be used to your advantage as part of your hedging strategy. For example, if you open a buy position for EURUSD, you can go short on USDCHF. If EURUSD decreases in value, the value of USDCHF will, in turn, increase, which will allow you to offset your exposure to USD and limit your potential losses.

Forex options hedging

It's also possible to use options contracts as a way to hedge against potential losses, and some even consider this strategy the most reliable Forex hedging strategy of all. When you buy an options contract, you acquire the right, but not the obligation, to buy or sell the underlying asset at a specified price within a specified time frame. So if you enter a long position on EURUSD and want to hedge against risk, you can buy a put option (or the right to sell the underlying asset) and use it to sell the currency pair at a more fair price in case the market moves against you.

Is hedging legal?

Hedging is considered legal in the majority of countries. However, some countries, like the US, prohibit the use of the same currency hedging. It doesn't mean that you as a user will be punished for using this Forex hedging strategy, but brokers based in the US won't be able to allow you the possibility of using this strategy with them. The reason why this ban is in place is that traders have to pay double spread for these trades, which benefits brokers more than it does traders. However, you can still use this strategy if you're trading through a non-US-based broker since many countries in the EU and Asia permit it.

Should you consider hedging your Forex trade?

Hedging is a powerful risk management strategy, but it does eat into your final profits, so using it for every trade just isn't feasible in the long run. So how do you know when is the time to open a hedge trade?

Well, the main thing to take into consideration is market volatility. If a currency pair you choose to trade is known for being volatile, hedging might be a good idea, as predicting future price movements is extremely hard. Generally, the more liquidity a market has, the more volatile it will be. So if you're trading a major currency pair like EUR/USD, you can expect it to be more volatile than less popular currency pairs.

Another thing to consider is the current situation surrounding the currency pair. If there is an event coming up that might affect the currency rates, you might have to prepare for the market to move against you, and opening a hedge trade is a sure way to help you mitigate potential impacts from that move.

And one more thing to take into account before opening a hedge trade is your current funds. When you open an additional trade, you have to pay transaction costs for it. Sometimes, these costs are reimbursed via a hedge trade; sometimes, they are not. So you need to calculate carefully whether hedging is actually going to save your money or if it's better to try other strategies.

How to exit a hedge

There are two ways you can exit a hedge, and they depend on whether you're going to keep your initial position open or not.

If the period of uncertainty has passed and you want to continue trading the initial position without having to keep the hedge trade open, you may simply close the hedge position.

However, if you need to execute your hedging strategy fully and close both positions, it's important that you do it at the same time to avoid a gap and potential losses. If you take too long to close one of the positions, you might hinder your whole hedging strategy and lose all your potential profits.

Conclusion

Hedging is a risk management strategy that can prove useful for managing risk in Forex trading. Like any other strategy, hedging has its advantages and disadvantages. Before deciding to use it, you should consider whether it suits your trading style, capital, and overall trading goals.

You can learn more about hedging and how to use it to avoid inflation with FBS Analytics.