What is Hedging in Forex?

By Paul Choufani, Updated on: Apr 07 2023.

Hedging in forex is a trade protection mechanism used by traders trading with foreign exchange currency pairs. Essentially, the trader adopts a strategy to protect the initial position he/she has opened from an opposing move in the market.

The tactic is normally used in the short term when the trader in question is concerned about a piece of news or an unexpected update of a fundamental nature which could trigger potential volatility in the currency markets. This is normally done through taking a position for the pair which is opposite to the original position, or through purchasing forex options. Hedging in forex is an important measure which traders use as part of their risk management strategies while trading in the market, since their primary goal has always been to protect their initial capital while attempting to successfully profit from financial markets which are traditionally uncertain and volatile.

How does Hedging in Forex Work

Hedging in forex normally takes place through the trader opening a position in the opposite direction to an original existing trade, in order to reduce the risk exposure of an existing position. Normally, the trader or investor carries out his/her risk analysis and quantifies the risk levels involved before instituting both the original and hedged trades. They would subsequently be responsible for controlling the level of change in their positions which takes place due to the ensuing price volatility for the market instrument(s) being traded.

Example of Hedging in Forex

In the chart above, reflecting the graph of the AUDUSD contract, we take the case where an investment bank instituted short positions at the 0.69 level in September 2022, represented by the orange circle. After the price fell, the bank decided not to close the trade for some reason, but was forecasting upward movement in November. It decided to open a long position at about 0.64, as it was expecting a price increase in the contract.

It would be able to benefit from the potential profits in the long position, despite potentially losing profits in the original short position. The aggregate change in profits due to both transactions is a consequence of the hedged trade, which would result in the original profit amount from the initial trade being protected.

Pros and Cons of Hedging in Forex

There are significant advantages and disadvantages when traders and investors engage in hedging activities in forex.

On the plus side, they have increased control on how much risk they are exposed to, and how much the potential reward would be. This is normally quantified by the trader prior to undertaking the hedged trade. Additionally, should an unexpected event happen, there is less possibility of portfolio damage since the hedge would provide increased diversification in the holding positions at hand.

As a bonus, hedging actually gives the opportunity to profit on a position that would maintain the account balance during a violent or unexpected price swing, before a reversal takes place leading to other positions going back to their original value.

On the other hand, a hedge is also likely to reduce the potential for profit. If a trader has an open position in profit, and the price continues to move in a certain direction after the trader implements a hedged trade in the opposite direction, then the hedged trade would be at a loss, nullifying the gains made by the original trade after the hedged trade was opened.

Moreover, hedging is not an ideal practice for beginners in trading, as it requires proper practice and education needed to handle opposing trades at the same time in what could be an unfamiliar market, reflecting the numerical and positional complexity of the hedging operation. There is also the risk of hedging resulting in increased losses in the portfolio or fund, due to some hedged trades not being correlated directly to initial positions, due to a different leverage or some other factor. This has the potential for aggregate drawdown or loss in the overall position when price volatility ensues.

Forex hedging strategies

There are a number of strategies which traders adopt while hedging in forex. The investor or trader would nominally choose the tactic (as well as the instrument) most suited to his/her conditions, which would depend on a variety of factors, including available capital and position size.

Hedging in Forex with CFDs

One classical tactic includes taking an operationally opposing position to the initial position he/she has taken in the market using a given CFD instrument. For example, if an investor or trader holds an initial long (buy) position on a CFD, such as the GBP/USD contract, but anticipates news which could potentially disrupt the market for this pair, he/she would open a short (sell) position on the pair as a hedge against the risk of a hostile market move to the original position. While the hedge mitigates the risk arising from the initial position in the short term, it also reduces the potential for profit from the original trade as well.

Hedging in Forex with Options

Another strategy utilized in forex hedging includes the purchase of forex options. Forex options are derivatives of the currency pairs being represented, and whose use depends on the tactic the trader utilizes in his/her trading operations. The option trade is an undertaking of a value exchange without the actual delivery of the physical asset, and it is popular due to the risk being limited to the premium paid to buy the option contract itself, as well as the very large upside if the trade goes in the desired direction. As a result, it serves as an effective forex hedging strategy used by the investor or trader, since it acts as a counter to the initial position taken in the forex cash market.

However, there are drawbacks to the options purchasing strategy. They include the likely possibility of a high premium being charged on the forex option, which is based on the expiration date of the contract, as well as the strike price. The strike price is the pre-specified future price at which the trader can buy or sell the contract. Additionally, forex options trading can be more complex than the cash market for forex contracts, as there are several simultaneous factors which determine the value of the options contract, such as market volatility and the time horizon for the expiration of the contract itself.

Hedging in Forex with Correlated Assets

Another strategy would be for the trader or investor to utilize two different currency pairs which are highly correlated either in a positive sense or a negative sense. For example, a long trade can be opened for the GBPUSD currency pair and a short trade can be opened for its GBPJPY counterpart. Here, as it is highly likely that both pairs move in the same direction due to the GBP factor, any drawdown or loss on one of the trades would be made up for by gains and profits in the other trade.

Consequently, the risk is heavily mitigated due to this hedging strategy. Yet for this tactic to work successfully with different currency pairs, it is essential that the trader does his/her research on both pairs involved in the potential hedge, to ensure that the correlation is high between them through their respective movements in the market. This is to guarantee that when the market volatility does ensue, whether it is based on a news update such as a Federal Reserve meeting or some other unexpected event, then the two current pairs in question would move as expected in the market.

Nullifying your open trade

This strategy is adopted after a trade has already been opened, and the trader opens a second trade in the opposite direction to the original trade in order to nullify or reverse the original trade’s gains or losses. For example, if the trader is currently in drawdown or at a loss in a long trade on USDCHF, he/she would open a short trade in order to remove the existing losses on the long trade. This is because a further drop in the USDCHF contract price would result in a gain on the short trade, which would mitigate the loss on the original long trade. Should the USDCHF price reverse upwards, then the short trade would be at loss while the original long trade would approach breakeven. In both cases, the short trade opened acts as an insurance policy for the original long trade which was at a loss.

Hedging in Forex the right way - Manage your risks

Despite the well-known advantages from hedging in forex, namely the control of risk and reward as well as the limitation of capital exposure on different time frames, especially during periods of exchange rate volatility and economic uncertainty, hedging as a strategy is not traditionally utilized by beginners in trading.

A trader would need to master technical and fundamental aspects in the market, as well as basic risk and emotional management skills, prior to engaging with hedging processes in forex. Trading is a game of numbers, and risk itself can be measured and quantified.

Risk management is a skill which needs to be practiced, at the levels of both the risk taken to open the initial trade, as well as the attempt to reduce the risk as a result of implementing the hedged trade. A hedged trade can produce profits in the short term, but if not done correctly, the whole endeavour may result in both trades resulting in losses, due to a combination of wrong position sizing and decision making as well as a lack of emotional control.

When hedging in forex, the aim should be clearly defined, whether it is to guarantee a certain sum of profit, to limit capital exposure or even to practice a certain hedging strategy. Moreover, the trader or investor would decide on the timing and conditions of a strategic exit from the hedge, which would be based on the risk exposure levels for both the initial and hedged trades and the need to guarantee some level of profit for at least one of the trades in the aggregate position.

Retail Vs. Institutional forex players

A forex hedge can be carried out by both retail traders as well as large financial institutions and establishments. For retail traders, as discussed previously, a hedge would involve opening a short position on a currency pair to counter a prior long position on the pair, or it would entail the opening of opposing positions on highly correlated pairs. Yet, retail traders would need to check with their brokers whether such hedging operations are available or permissible, as not all trading and brokerage firms provide this particular service.

With respect to larger banks and financial establishments, we can study the case of a European investment bank in the United States as an example. The bank may seek to hedge its American-based profits through the purchase of a put contract option, since it is due to sell US dollars prior to a scheduled repatriation of its profits back to Europe.

The purchase of the put option by the investment bank would lock in the worst possible rate for the US dollar, by which the bank would be able to exercise its option to sell its dollar profits at the prespecified rate by expiry of the option contract. This rate would apply in case the US dollar falls to its strike price. Otherwise, the bank will allow the contract to expire without utilizing the option as it would be able to sell its US dollar profits into euros for a better rate in the market.

Essentially in both cases, whether the options contract is exercised or not, the cost of the original hedge remains, and is represented by the cost of the put contract purchased by the European investment bank under study.

Institutional hedging in forex is an important macro-transaction undertaken by banks and other financial establishments to protect their capital and minimise institutional risk and exposure against foreign currency exchange rate fluctuations. The considerations banks have with regards to their decision-making processes and financial operations account for billions of dollars of funds and capital in their respective portfolios.

Conclusion

Hedging is a widely-used measure across a variety of financial market asset classes, by a diverse set of market players. It has important uses and implications in the market, and remains a useful tool in the arsenal of risk management practices in forex. Like any strategy in trading or in investing, it is important to hedge in the correct way in order to acquire its benefits and avoid its pitfalls, and this can only be done through education and practice. Hedging in forex is set to remain as a dominant tactic utilized in a globalized market, due to retail traders being exposed to a variety of instruments and multinational institutions looking to protect their foreign investments and profit margins.

Frequently Asked Questions

Is hedging a good strategy in forex?

Hedging is a good strategy to utilize in forex for risk management purposes during trading. The investor or trader could seek to utilize this proven tactic in order to achieve his/her specific goal in the process. Used correctly, it is effective in protecting capital and profit margins for both retail and institutional players in the market.

What is hedging in currency trading?

In currency trading, hedging involves opening a position in the opposite direction to an original position being taken, mostly executed to manage the position risk and protect the capital pertaining to the trader or investor.

Is hedging like gambling?

Hedging is a process used for risk management purposes in trading, which in its very nature, is antithesis to gambling activities. Gambling is an arbitrary process by which bets are made based on arbitrary and random decision-making, with no accounting for risk margins and often with emotional factors at play. Hedging seeks to mitigate risks during trading activities. Gambling, however, is itself a process of engaging in highly risky transactions without performing the underlying technical and/or fundamental study, and without accounting for the risk involved in the dealings.