Forex hedging involves buying or selling of correlating currency pairs to stay protected from fluctuating exchange rates. Forex hedging protects the long or short position of a currency pair against downside or upside risk.
The most common forex hedging strategies are:
The following hedging strategies are used by forex traders to secure their currency positions:
A Forex trader may hedge in two ways as detailed below.
If a trader faces negative price moves on ‘euros-to-dollars’ currency pair, he/she may hedge against an unrealized loss by selling ‘euros-to-yen’ currency pair. This will partially adjust the offset. The 'long' and 'short' positions for the Euro, which occur at the same time, are a hedging strategy.
Traders use the difference of interest rates or charges between two brokers as a hedging tool. In this type of hedging, a trader needs to use two brokers. One broker who charges or pays interest at end of day, and the other who does not charge interest. A trader needs to open position on the same currency pair with both the brokers. If the currency pair underperforms, the trader pays interest to one broker and earns the ‘rollover’ interest of the other broker. Alternately, if he earns profits, he would gain from both the brokers.
Traders use forex hedging strategies to limit risk of their forex account. Forex hedging can be a bigger part of the trading plan if done carefully. Forex hedging must be used by experienced traders, who understand the swings and timings of the forex market.
Forex hedging as a strategy is not for the retail forex trader as it opens multiple options for risk. The 'retail hedger' needs to take multiple positions as holding on to a ‘losing position’ involves exposure to greater risk. Hedging without sufficient trading experience can be harmful for a trader.
