A hedging strategy in forex is a short-term method of risk management when holding a currency pair position, by taking a position in the opposite direction, buying and selling correlated pairs, or purchasing forex options.
In my guide, I will explain exactly what forex hedging is, show you the best forex hedging strategies and how they work, and the various pros and cons of forex hedging.
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- Forex hedging strategies are methods of risk management that could prevent you from incurring heavy losses on your forex trades by anticipating unfavourable price movements.
- Popular forex hedging methods include using opposing orders, correlated currency pairs, and forex options contracts.
- While hedging is predominantly about mitigating risk, you could even profit while using hedging strategies in some cases.
What are forex hedging strategies?
Forex hedging strategies are used by traders as a means of risk management once a position is open.
There are different methods of hedging forex trades, but they all have the same purpose – to “cover” any losses you may incur when your original trade does not go as planned.
In some cases, if there happens to be a press release, market-specific news, or financial events, market volatility may increase, making it difficult for traders to accurately speculate on the direction of price movements.
Hedging can also be used to complement your regular trading strategy as a way of reducing the severity of any losses you incur.
By having a hedging strategy in place, forex traders could minimise risk by opening a position that anticipates financial markets’ unpredictability.
What different forex hedging strategies are there?
Forex hedging refers to the general act of covering a position’s risk with a contrasting order, rather than a specific action. There are several popular hedging strategies that can be used.
Some techniques may not be available to you, depending on where you live. So, it can be useful to familiarise yourself with the different trading strategies of forex hedging.
Direct forex hedging strategy
Direct hedging in forex is the most literal form of hedging as a risk management technique, and involves a trader opening a directly opposing position to their original.
This way, should your theory about the prospective price movement prove incorrect, you have a contradictory position to offset any losses you may face.
Many businesses use a direct forex hedging strategy to protect themselves from exchange rate fluctuations when operating overseas.
The simplest form of direct hedging would involve using positions of opposite directions (long and short) on the same currency pair, so movements are directly offset.
To provide an example, this would mean simultaneously opening a short and long position on a currency pair, such as EUR/USD. The second position would act as the direct hedge.
This method is actually illegal in the US, so you will need to explore a different hedging strategy if you are investing through a US broker.
Pros and cons of direct hedging
- Direct hedging forex strategies are relatively simple to understand, compared to more complex methods
- Trades are kept within the same market which could make it easier to keep track of the differences
- Any losses are immediately balanced out.
- Traders in the US will likely be unable to access this method
- While you remove the risk of loss, you will often also wipe out any profits
- The amount paid as “slippage” is likely to increase by opening a second position.
Forex correlation hedging strategy
When trading forex, you may notice that some currency pairs move in similar ways to others. These are known as “correlating currency pairs”.
For example, GBP/USD may be increasing in price at the same time as GBP/JPY or EUR/USD. This is known as a “positive correlation” and shows how the two different markets are affected in similar ways – upward or downward.
On the other hand, there are also negatively correlated pairs. This means that, as one currency pair increases in value, the second pair in question decreases at a similar rate.
For example, as GBP/USD increases in value, markets that are negatively correlated such as USD/JPY tend to decrease in value at a comparable rate.
Since some currency pairs can have correlations beyond 90%, these could make ideal assets to make hedging trades. Using figures from Logikfx, we can see how EUR/USD and GBP/USD share an 89% positive correlation.
A forex correlation hedging strategy would use two currency pairs that are highly positively correlated to offset the risk of their trade – because you may not be able to open an opposing order for the same forex pair, using one that moves almost identically could be the next best thing.
In this case, you would approach the two separate forex pairs as if they were same pair, as is done through direct hedging – by opening a short position, for example, on one forex pair while opening a long position on another pair that is highly correlated with the currency pair of the original trade.
Pros and cons of forex correlation hedging strategies
- It works in a similar way to direct hedging but is available to traders in the US
- The method isn’t exclusive to advanced traders
- Many currency pairs are correlated, giving you multiple options.
- Movements aren’t 100% correlated so there could be some discrepancies between different currency markets
- Newer traders may find it hard to fully understand or use it effectively
- Correlated currency pairs could be affected by market-specific, forex news that impacts one more than the other, derailing your hedge.
Forex options hedging strategy
Options trading can provide another method of hedging forex trade positions, specifically utilising the time-sensitive nature of options trading.
Options contracts use call (buy) and put (sell) orders to create a prospective position that a trader has the choice to take or not – there is no obligation to take an options trade once the contract has been made, although there will likely be a small premium to pay either way.
It works by opening a position – long or short – and creating a call or put contract slightly above or below your initial entry in the opposite direction.
For example, you may open a long trade on GBP/USD at 1.21. In order to potentially hedge your losses in the event the pound depreciates against the dollar, you could purchase a put option at, perhaps, 1.20 – technical indicators could give you greater insight as to where to place your order.
This way, you have a position that you have the choice of opening once the contract reaches its expiration date.
Doing so is not free, however, and you will likely be charged a premium that is paid to the other party of the trade. This is charged whether you take the position outlined in the options contract or not.
Again, you have the right but not an obligation to take the trade outlined in an options contract. So, if you don’t need the price outlined in it, you do not have to take it.
Pros and cons of forex options hedging strategy
- Reduce the risk in your trade without passing up entirely on the returns
- You have the right, not the obligation, to take the position
- Options can be cheaper than the alternative hedging strategies.
- You could end up losing money on your trades if the markets move dramatically against you
- Premiums can be expensive if the outcome is likely to hurt the offerer
- You have to pay the premium regardless of whether you take the position or not.
How to choose the best forex hedging strategy
There are various forex hedging strategies. Using the style that’s right for you can have a significant impact on your trading technique and risk management, so it can often principally depend on the way you like to trade.
Because choosing the right strategy to hedge your forex trades could be important to your success in the markets, it’s useful to consider which variation is likely to benefit you the most, as traders’ preferences often differ.
For beginners, it could be sensible to use a simple forex hedging strategy. While this can vary from person to person, using a direct hedging strategy will likely be the easiest method for learners to understand.
Even though you have two trades to keep track of, it usually isn’t difficult to assimilate the price difference between the two positions. The “like for like” nature of this method makes it relatively simple to understand, which could in itself help novice traders to prevent unnecessary losses through lack of comprehension.
Traders with more time in the forex market will likely have a better grasp of the nuanced relationships between different markets.
Because of this, using more sophisticated forex hedging techniques could benefit an educated trader. As such, a correlation forex hedge strategy could prove to be one that experienced traders prefer.
Similarly, if you live in the US, you may be blocked from using the direct hedging method through which you open opposing orders on the same asset.
Additionally, it may take an experienced mind to not panic when the two correlated currency pairs don’t have identical price action, while those with less time in the financial market may be prone to indecision during such conditions.
So, if you feel comfortable gauging the slight variations in price between multiple currencies, this method could be useful for you.
Why should you use forex hedging strategies?
Forex hedging strategies are ultimately methods of risk management while trading.
Trading financial markets, especially with margin or leverage, can carry extreme risk and you could lose more money than you anticipated if a trade goes wrong.
On top of this, it can become very difficult to close open trades when market conditions are volatile.
Not only could using a hedging strategy help you to reduce losses you face while trading, but it can also give you peace of mind, knowing that your existing position has some degree of cover in the event of unfavourable price movements.
Without a hedging strategy in place, you could have few proactive means of managing the level of risk a certain position carries.
Also, if a trade is significantly wrong, having a hedge position in place could even make forex hedging profitable, if you manage your initial, losing trade appropriately.
Overall, you could use forex hedging strategies to:
- Actively manage the risk exposure of a trading position, or multiple positions
- Offset any losses you may face
- Gain peace of mind, knowing you have measures in place should your trade be unsuccessful
- Profit from the trade acting as a hedge in some cases.
Can you still lose money using forex hedging strategies?
Just because you employ a hedging strategy to offset your losses, you aren’t immune to losing money.
Firstly, the hedge itself isn’t a guarantee of cover – it still requires you to appropriately manage the two positions.
Discerning when to close each trade is an important decision that could affect the success of your hedging strategy and will ultimately be your own decision.
Also, slippage – which is the price paid by a trader to cover the difference between the bid and ask prices – occurs when you open almost any trading position. This often means you are automatically put at an initial loss.
This is relevant to both your initial trade and the subsequent hedging trade. So, effectively doubling the slippage you have to pay for could make you more likely to lose money.
Another factor contributing to whether or not you lose money while using hedging strategies is the premium you have to pay on options contracts.
This fee is charged regardless of whether you take the position outlined in the contract, and could affect your profitability while trading forex with this hedging strategy.
Best Forex Hedging Strategies FAQs
Is hedging illegal in trading?
Is hedging profitable?
This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
Investments carry risk. The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.