Hedging forex may become necessary if you want to protect yourself from the risk of losses associated with the fluctuation of currency prices. What hedging does, is protect your position against losses that may arise from undesirable movements in the prices of the underlying currencies. It may be likened to purchasing insurance against the possibility of loss. Essentially, hedging may be done directly or indirectly.
With direct hedging, the trader would place a second trade that takes the opposite position to the initial trade. For example, your initial trade may be to go long GBP/USD. To hedge against this, you may decide to go short on the same pair. This is known as a “perfect hedge”. Despite the fact that your net profit is likely to be zero in such circumstances, it allows the trader to be able to make more money without increasing the risk, if he can time the market correctly. Some may argue that it is better to close out the initial trade and to open a new position that seems more lucrative. While that may be true, it is really up to the trader to decide which tactic would work better for him/her.
Bear in mind, however, that not all brokers will allow for direct hedging. In such cases, the trader would need to use indirect forex hedging to protect against the risk of losses. One way of hedging forex indirectly is by trading multiple forex pairs. In this instance, you would go long with one currency pair and short the other pair. The challenge with this method, however, is that fluctuations in the currency pairs are very likely to occur, creating imbalances that may not work out in the trader’s best interest. This method of forex hedging requires lots of skill and the ability to accurately interpret the direction in which the market will go.
Forex Hedging with Options
Another way that a trader can hedge against loss in forex trading is by using options. With this method, the trader would purchase either a “put” or a “call” option which gives him/her the right to buy or to sell a specific currency pair within a certain timeframe and at a specific price, called the “strike price.” Using options to hedge is an example of an “imperfect hedge” because it only mitigates some of the loss, not 100% of it.
Some forex traders hedge against losses by trading with a correlated currency pair. The MetaTrader4 Supreme edition has a feature that allows traders to view the correlation between currency pairs and therefore make more informed hedging decisions. If this is your chosen method of hedging, you should choose to hedge with a currency pair that is negatively correlated with your chosen currency pair. This is called a market neutral strategy and it only provides a partial hedge. The reason is that the currency pairs are not likely to be perfectly negatively correlated.
Forex hedging is a risk-mitigation strategy that traders can implement to protect their trading positions.