Currency risk is the danger of losing capital due to changes in forex prices. In the context of trading, this is the risk to a trader’s portfolio if currency markets experience strong price changes.
Trading forex itself can be risky, but it’s not just the forex markets that can be directly affected by currency risk.
Due to the interconnectivity of the financial markets, a significant price change in one currency can impact several other currencies, or even other markets such as shares, indices or gold. Imagine you’ve bought gold in USD. If a Federal Reserve interest rate decision causes a depreciation of the dollar, you will lose money on your position as a result of currency risk.
How to hedge against currency risk
To hedge against currency risk, you need another position that will earn you a profit if currency risk causes an existing trade to lose money.
This could mean opening an opposing position for the same value on the same market. This will cancel out your initial trade and mean any loss suffered will be recouped in profit made from your hedged position.
Alternatively, you could trade a forex pair that will earn you profit if a particular currency moves a certain way. For example, if you’re worried about a rising US dollar hurting your long gold position, you could open a short position on GBP/USD. If USD goes up, any losses in your gold trade may be offset by profits from your GBP/USD trade.
One popular way that traders hedge against market risk is to invest in safe-haven assets. These are markets that don’t typically experience heavy volatility and tend to hold an intrinsic value over a long-term period. Traders will invest in safe-haven assets, such as Gold, during market instability to protect their funds.
Additionally, you can protect against currency risk by applying stop-loss orders to your open positions. These automatically close out your trades if the market price falls below a certain level set by you. You will make a loss on the trade, but it protects you from incurring more substantial losses caused by a sudden or drastic change in currency value.