What does hedging mean in forex?
Hedging in forex is the method of reducing your losses by opening one or more currency trades that offset an existing position. The goal of hedging isn’t necessarily to completely eradicate your risk, but rather to limit it to a known amount.
The forex market is the largest and most liquid market in the world, which makes it extremely volatile. While this volatility is often viewed as an accepted part of the FX trading experience, various hedging strategies can be employed to reduce the level of currency risk associated with each position.
Types of currency risk that forex hedging can protect against include changing interest rates, inflation levels, and unexpected news.
How does hedging work in forex?
Hedging forex works by opening a position – or multiple positions – that move in a different direction from your existing trade. The hope is that you’ll create as close to a net-zero balance as possible.
While you could just close your initial trade, and then re-enter the market later, using a hedge means you can keep your first trade on the market, and make money with a second.
Forex hedging strategies
Various hedging strategies can be used to reduce currency risk exposure. The two most common forex hedging strategies are:
- Direct hedging
- Correlation hedging
1. Forex direct hedging strategy
The first strategy is known as a direct forex hedge. This is when you already have a position on a currency pair, and you open the opposite position on the same pairing.
For example, if you were long on GBP/USD, you would open a short position with the same trade size.
The outcome of this trade would be a net profit or loss of zero, depending on the costs of opening each trade. While a lot of traders would simply close out the initial position, accepting any loss that they incurred, a direct hedge would enable them to make money with the second trade that would prevent this loss.
Direct hedges aren’t necessarily facilitated on a lot of trading platforms, as the result is a complete net off of the trade.
2. Forex correlation hedging strategy
A common hedging strategy is seeking a correlation between currency pairs. This would involve selecting two currencies that typically have a positive correlation (move in the same direction) and then taking opposing positions on them.
For example, GBP/USD and EUR/USD are the most frequently cited as having a positive correlation. This is as a result of the relationship between the UK and EU both in terms of geography and political alignment – although the latter could change in the coming years.
So, if you had a long position on GBP/USD, you could hedge it with a short position on EUR/USD.
When you use a correlative hedging strategy, it’s important to remember that your exposure now spans multiple currencies. While the positive correlation works when the economies are moving in tandem, any divergence could impact the way each pair moves – and in turn your hedge.
How to hedge forex
- Open an account with FOREX.com or log in
- Find the currency pair you want to trade
- Choose your position size – ensuring it balances any existing positions
- Place the trade and monitor the market
Most forex hedges will be performed using trading instruments known as derivatives. The most common products are forwards, CFDs and options.
Before you start hedging, it’s vital to have adequate experience and knowledge of the forex market, how it moves, and so on.
Hedging forex with CFDs
Contracts for difference are a popular means of hedging forex (and other markets) due to the fact you can offset any losses against profits for tax purposes,1 and speculate on falling prices.
You can use CFDs to trade more than 12,000 global markets – including 84 currency pairs – without taking ownership of any physical assets.
Want to trade forex via CFDs? Open an account with us to get started today.
Hedging forex with options
A forex option is an agreement that gives you the right – but not the obligation – to buy or sell a currency at a set price (strike price) on a set date of expiry. There are two types of options: puts, which give you the right to sell a currency, and calls that give you the right to buy a currency.
Options are a popular hedging tool as they’re limited risk when buying. If your hedge didn’t go the way you’d planned, you could leave your option to expire worthless and only lose the premium you paid to open the position.
Hedging forex with forwards
Currency forwards are similar to options, in that they create a contractual agreement to exchange a currency at a set price on a future date. Unlike options, there is an obligation to fulfil the contract at expiry, either in cash or physically.
As with options, hedging with FX forwards can be a way to lock in a price in advance, and therefore hedge against any adverse market movements.
Forwards are often confused with futures contracts – although they work in much the same way, forwards are over-the-counter products, rather than exchange traded.
Forex hedging example
Let’s say you were long on USD/JPY, having opened your position for ¥108.50. You expect a sharp decline in the Japanese yen today, so decide to hedge your exposure using a daily put option on USD/JPY with a strike price of ¥106.
If at the time of expiry, the price of the yen had fallen below ¥106, your option would be in the money. The profit you’d earned could be used to offset any losses to your long USD/JPY trade.
However, if the yen had risen in value instead, you could let your position expire worthless and only pay the premium. The profit to your long trade could offset some or all of this cost.
1 Tax laws are subject to change and depend on individual circumstances. Please seek independent advice if necessary.