What Is Forex Hedging? How it is Used in Forex?
Hedging is often used by traders to safeguard themselves from the unpredictable price fluctuations that occasionally take place in the foreign exchange market.
In forex trading, hedging is heavily used by traders and corporations alike to protect their positions while trading particular currency pairs.
Traders usually resort to hedging when they are worried that some random upcoming events in the market will affect currency prices negatively.
Large corporations also use hedging if they find out that they have gained unwanted exposure to any foreign currency’s value as well as the price of particular raw materials.
An example where hedging can protect a trader from suffering a decline in value is if he chooses to go for a long position strategy on a foreign currency pair and the market trend starts going in a downward direction.
Therefore, it can be said that hedging is a type of short term protection tactic used by forex traders to safeguard their positions when they require it the most.
There are numerous ways of hedging in fx trading. In this article, we will talk about all of them in detail.
Forex Hedging Meaning
By now you must have grasped that fx hedging is not something that can be used to make money while trading fx. It is a tactic that is used to safeguard oneself from future losses.
Furthermore, currency hedging is only capable of protecting you from a portion of the risk you are safeguarding against.
Fx hedging itself will cost you and if that you invest too much in just hedging then you will end up wasting your money as the cost we of hedging itself will eat away at your profits.
It should be noted that not all brokers allow you the luxury of currency hedging so be sure to go through their user policy with a fine-tooth comb before signing up.
Now that we have discussed fx hedging, let us take a look at how at the strategies that are used in hedging.
There are multiple ways of incorporating fx hedging into your trades to safeguard yourself from the fluctuating prices of currency pairs. Some noteworthy hedging strategies are:
Simple Forex Hedging: Simple hedging or direct hedging is one of the most common and regularly used hedging strategies.
In direct hedging, the trader goes long on a currency pair but at the same time, goes short on it and puts that currency pair up for sale.
This gives the trader two opposite options that let him keep his original position intact while ensuring that it does not have to be closed on a loss.
Multiple Currencies: The above strategy works well for traders dealing in only one currency pair at a time. But what if you are trading in multiple currency pairs simultaneously?
This is where the multiple currency hedging comes in.
If the trader decides to go long on a specific currency pair and short on another pair that has a common currency in both pairs, then the trader has maximum protection for that particular common currency.
However, the remaining two currencies will remain exposed as this strategy doesn’t protect against currencies that are not common in both positions.
Forex Options: This is another hedging strategy in which traders agree to exchange at a price in the future that is agreed upon by both parties.
Keep in mind that this tactic may still bring some losses on the trader which is why it is also known as an imperfect hedge in the trading community.
A Simple Hedging Example
Let us take the example of a forex trader who has decided to go long on the pair JPY/USD.
The trader has predicted that the pair will go higher in value but he also wants to safeguard himself if his prediction is incorrect.
Therefore, he decides to hedge and he purchases a put option contract.
If the trader’s prediction comes true then his JPY/USD position will continue to hold or go higher and the trader can continue to hold his position in the hopes of making bigger profits.
If the trader’s prediction proves to be wrong and the value of the JPY/USD pair starts to dip then the trader’s decision to use hedging will come in handy and protect him from the upcoming dip in currency value.
Either situation is a win-win for the trader here. Another important thing to note here is that hedging isn’t directly making a profit for the trader.
It is merely reducing his risk in case his prediction is incorrect and the market trend goes in a direction that can be harmful to him.
How Important Is Hedging In Forex
As we mentioned in the above example, forex hedging is not a strategy that is used by traders to boost their profits.
Hedging is more like a security blanket that ensures that your positions are not too exposed to the perils of the highly volatile market forces.
Whether hedging is a great tool or not is ultimately the trader’s decision as they can choose to implement it in their trades or completely ignore them.
Traders are free to use hedging although there might some special circumstances where they might not be able to do it.
That situation may arise if the broker you are using does not allow the implementation of forex hedging in the trades conducted on their platform.
Forex Hedging Cost
Forex hedging does not carry a fixed fee although what you have to pay may depend on the broker with whom you are registered.
In most cases, traders might have to pay a commission to their brokers or a slice of the spread of the market in which they are trading in.
The trader has to make an educated guess before he starts hedging as investing too much on an extra security blanket in trading can eat away at their profits.
At the end of the day, a trader may or may not decide to use forex hedging to secure their positions if it does not appeal to them.
There might be a variety of reasons for that which includes a high commission being charged by the broker on their hedges or simply a lack of understanding by the trader.
Furthermore, if you decide to use hedging and the market trend starts going in a positive direction then the cost of that hedge can be considered dead weight as you might have made more money without that hedge.
If you are a beginner in forex and are looking to start fx hedging then there are a few things you should keep in mind before you even start.
The first thing is that hedging is not a magic spell that will somehow protect all of your money regardless of the market conditions.
Secondly, fx hedging is merely a way of bracing yourself from the damages that may occur due to the various unpredictable fluctuations in prices in the future.
You may realize that sometimes partial hedges will work out in your favor while other times you may observe that closing a trade or reducing an open position will be your best option.
Different scenarios call for different actions which is why you have to read each and every single trade differently.