What is forex hedging?
Forex hedging is the act of strategically opening additional positions to protect against adverse movements in the foreign exchange market.
Hedging itself is the process of buying or selling financial instruments to offset or balance your current positions, and in doing so reduce the risk of your exposure. Most traders and investors will seek to find ways to limit the potential risk attached to the exposure, and hedging is just one strategy that they can use.
Why hedge forex?
A trader might opt to hedge forex as a method of protecting themselves against exchange rate fluctuations. While there is no sure-fire way to remove risk entirely, the benefit of using a hedging strategy is that it can help mitigate the loss or limit it to a known amount.
Currency hedging is slightly different to hedging other markets, as the forex market itself is inherently volatile. While some forex traders might decide against hedging their forex positions – believing that volatility is just part and parcel of trading FX – it boils down to how much currency risk you are willing to accept.
If you think that a forex pair is about to decline in value, but that the trend will eventually reverse, then hedging can help reduce short-term losses while protecting your longer-term profits.
Three forex hedging strategies
There are a vast range of risk management strategies that forex traders can implement to take control of their potential loss, and hedging is among the most popular. Common strategies include simple forex hedging, or more complex systems involving multiple currencies and financial derivatives, such as options.
Simple forex hedging strategy
A simple forex hedging strategy involves opening the opposing position to a current trade. For example, if you already had a long position on a currency pair, you might choose to open a short position on the same currency pair – this is known as a direct hedge.
Though the net profit of a direct hedge is zero, you would keep your original position on the market ready for when the trend reverses. If you didn’t hedge the position, closing your trade would mean accepting any loss, but if you decided to hedge, it would enable you to make money with a second trade as the market moves against your first.
Some providers do not offer the opportunity for direct hedges, and would simply net off the two positions. With IG, the force-open option on our platform enables you to trade in the opposite direction from your initial trade, keeping both positions on the market.
Multiple currencies hedging strategy
Another common FX hedging strategy involves selecting two currency pairs that are positively correlated, such as GBP/USD and EUR/USD, and then taking positions on both pairs but in the opposite direction.
For example, say you’ve taken a short position on EUR/USD, but decide to hedge your USD exposure by opening a long position on GBP/USD. If the euro did fall against the dollar, your long position on GBP/USD would have taken a loss, but it would be mitigated by profit to your EUR/USD position. If the US dollar fell, your hedge would offset any loss to your short position.
It is important to remember that hedging more than one currency pair does come with its own risks. In the above example, although you would have hedged your exposure to the dollar, you would have also opened yourself up to a short exposure on the pound, and a long exposure to the euro.
If your hedging strategy works then your risk is reduced and you might even make a profit. With a direct hedge, you would have a net balance of zero, but with a multiple currency strategy there is the possibility that one position might generate more profit than the other position makes in loss.
But if it doesn’t work, you might face the possibility of losses from multiple positions.
Forex options hedging strategy
A currency option gives the holder the right, but not the obligation, to exchange a currency pair at a given price before a set time of expiry. Options are extremely popular hedging tools, as they give you the chance to reduce your exposure while only paying for the cost of the option.
Let’s say you’re long on AUD/USD, having opened your position at $0.76. However, you are expecting a sharp decline and decide to hedge your risk with a put option at $0.75 with a one-month expiry.
If – at the time of expiry – the price has fallen below $0.75, you would have made a loss on your long position but your option would be in the money and balance your exposure. If AUD/USD had risen instead, you could let your option expire and would only pay the premium.
Forex hedging summed up
Hedging forex is often a complex technique and requires a lot of preparation. Here are some key points for you to bear in mind before you start hedging:
Forex hedging is the practice of strategically opening new positions in the forex market, as a way to reduce exposure to currency risk
Some forex traders do not hedge, as they believe volatility is part of the experience of trading forex
There are three popular hedging strategies: simple forex hedging, multiple currencies hedging and forex options hedging
Before you start to hedge forex, it is important to understand the FX market, choose your currency pair and consider how much capital you have available
It is a good idea to test your hedging strategy before you start to trade on live markets