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What is Forex Hedging? A Guide to Hedge Currency Risks

Forex hedging allows a trader to minimize investment risks from potential market downturns. By hedging, you are protecting your investments against market fluctuations that would result in huge losses. This article will give you a detailed insight into hedging, explain how to hedge in Forex, the advantages of Forex hedging.

Reasons to Hedge Forex Trades​

Choosing your hedges carefully can help you make your trading plan more successful. It should only be undertaken by experienced traders who have an understanding of market swings and timing. You could quickly lose your account balance if you attempt to hedge without adequate trading experience.

Here is what you need to know about Forex hedging:

  • It isn’t a magic trick that guarantees you profit regardless of what happens in the market
  • It serves as a protection against potential damage caused by adverse price fluctuation in the future
Sometimes simply closing out or shrinking an open position can be the best course of action. Sometimes, however, a hedge, or even a partial hedge, seems to be the best choice. Consider what is most appropriate for your risk tolerance.

Hedging Strategies in Forex

Forex traders have a wide range of risk management strategies at their disposal to handle potential losses, and hedging is one of the most popular. Various methods of hedging are available in the Forex sphere. The three most effective Forex hedging strategies are as follows.

1. Forex Direct Hedging Strategy

A Forex Direct Hedging Strategy is a simple strategy which involves opening an opposite trading order to the current active trade. To illustrate, consider if you already hold long positions on a currency pair, but then decide to open a short position on the same currency pair – this is known as a direct Forex hedging strategy.

Let's say a Forex trader decides to purchase the GBP/USD currency pair using a "buy" order, then creates a "sell" order to profit from the potential rise or fall in price. As a result, the trader is hedging against any arising from possible price movement against his long position, which is more likely to reduce his losses.
The outcome of the direct hedging strategy would be a zero net profit or loss, depending on the costs associated with opening each trade. However, you can still keep your original position on the market and take advantage of the reversal. While many Forex traders would simply exit their initial position accepting the loss that they incurred, if you opt for a direct hedge, the second hedge position would profit you if the market moved against your first trade.

This approach has the benefit that it allows traders to protect their trades from potential losses while utilizing a completely legal method. However, some Forex brokers or platforms do not provide the option to create a direct hedge order, and they simply net off the two positions. Thus, it is a good idea to investigate and confirm the availability of hedging options before committing to a trading platform or broker.

2. Forex Correlation Hedging Strategy

Forex correlation hedging strategy is one of the popular methods of hedging Forex trades by using highly positively or negatively correlated currency pairs. A positive correlation indicates that when the price of one pair rises, the price of the other pair rises as well. While, a negative correlation means that if the price of one pair goes up, the price of the other pair will decline.

In this case, we can choose two Forex currencies that typically have a positive correlation (move in the same direction) and then take opposing positions. GBP/USD and EUR/USD are among the most commonly cited currency pairs with a positive correlation. This is due to the UK and EU relationship, both in terms of geography as well as political alignment – though the latter have changed recently.

Sometimes, the degree of positive correlation between those pairs is greater than 90%. That basically means that those two pairs move the same way 90% of the time. Therefore, if you had a long position on GBP/USD, you could hedge it using a short position in EUR/USD.


Here is an example of a GBP/USD and EUR/USD chart showing positive correlation hedging, for a better understanding of the currency correlation.

Consider the example of taking a short position on EUR/USD, but opening a long position on GBP/USD to hedge your USD exposure. Suppose the euro fell against the dollar, then your long position on GBP/USD would have lost money, but your EUR/USD position would have made money. The hedge would compensate for any loss on your short position if the dollar fell.
If you use a correlation strategy, you should remember that hedging more than one currency pair does come with a certain level of risk. Even though you hedged your dollar exposure in the example above, you would also have opened yourself up to shorting the pound and longing the euro. While a direct hedge would result in a net balance of zero, with a correlation Forex hedging strategy, one position might generate more profits while the other might incur losses.

3. Forex Options Hedging Strategy

Forex traders who do not want to open several positions for hedging can use options as an alternative. It enables them to buy or sell currency at a predetermined rate at a specified time in the future.

Let's say a trader decided it would be best to open a long AUD/NZD position at level 1.05 based on a thorough analysis. So far, everything looks quite straightforward. If the Australian dollar appreciates against the New Zealand dollar, let's say to the 1.07 level, then one can make some nice profits on the trade.

But a trader who is concerned about possible losses, however, can purchase a put option at 1.00. For instance, if the Australian dollar falls to parity with the New Zealand dollar because of a sudden rate cut, weakening economy, or any other reason, the individual can purchase the option and close the position, limiting losses.
Many Forex traders are considering this approach as a cheaper alternative to other hedging methods. The reason is that if the market turns against the position, the premium paid will be much smaller than the loss that is otherwise likely to be incurred.

Forex CFD Hedging Strategy

CFD (Contracts for difference) have become a popular way to hedge forex (as well as other markets) due to the fact that they can be used to offset losses against profits for tax purposes, as well as to speculate on falling prices. CFDs allow traders to trade globally on thousands of markets, including multiple currency pairs, without having to hold any physical currency.

This type of Forex hedging strategy protects against inflation, fluctuations in commodity prices, currencies, and changes in central bank interest rates. Furthermore, it saves brokers time by allowing them to manage their portfolios in a volatile market environment.

Is Forex Hedging Legal?

Hedging with Forex trading is illegal in the United States and some regions. However, it is important to note that not every form of hedging is prohibited in the US, but the law is focused on the buying and selling of currency pairs at the same or different exchange rates. Due to this, the CFTC has implemented trading restrictions for Forex traders.

Despite this, forex hedging is legal with many Forex brokers worldwide, including those in Asia, Australia, and Europe.

Original Article: What is Forex Hedging? A Guide to Hedge Currency Risks
Disclaimer: This post is from Aximdaily and it is considered a marketing publication and does not constitute investment advice or research. Its content represents the general views of our editors and does not consider individual readers' personal circumstances, investment experience, or current financial situation.
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