Learn About Using Forex Hedging

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Hedging is simply coming up with a way to protect yourself against a big loss. When you buy car insurance, you're protecting or hedging against the chance of having an expensive accident.

In forex, think of a hedge as getting insurance on your trade. Hedging is a way to reduce or cover the amount of loss you would incur if something unexpected happened.

Simple Forex Hedging

Some brokers allow you to place trades that are direct hedges. A direct hedge is when you are allowed to place a trade that buys one currency pair, such as USD/GBP. At the same time, you can also place a trade to sell the same pair.

While the net profit of your two trades is zero while you have both trades open, you can make more money without incurring additional risk if you time the market just right.

The Protection of a Hedge

A simple forex hedge protects you because it allows you to trade the opposite direction of your initial trade without having to close your initial trade. One can argue that it makes more sense to close the initial trade at a loss, and then place a new trade in a better spot. This is one of the types of decisions you'll make as a trader.

You could certainly close your initial trade, and then re-enter the market at a better price later. The advantage of using the hedge is that you can keep your first trade on the market and make money with a second trade that makes a profit as the market moves against your first position.

Undoing a Hedge

If you suspect that the market is going to reverse and go back in your initial trade's favor, you can always place a stop loss on the hedging trade, or just close it.

There are many methods for hedging of forex trades, and they can get fairly complex. Many brokers do not allow traders to take directly hedged positions in the same account so other approaches are necessary.

Multiple Currency Pairs

A forex trader can make a hedge against a particular currency by using two different currency pairs. For example, you could buy a long position in EUR/USD and a short position in USD/CHF. In this case, it wouldn't be exact, but you would be hedging your USD exposure. The only issue with hedging this way is you are exposed to fluctuations in the Euro (EUR) and the Swiss(CHF).

This means if the Euro becomes a strong currency against all other currencies, there could be a fluctuation in EUR/USD that is not counteracted by your USD/CHF trade. This is generally not a reliable way to hedge unless you are building a complicated hedge that takes many currency pairs into account.

Forex Options

A forex option is an agreement to conduct an exchange at a specified price in the future. For example, say you buy a long trade position on EUR/USD at 1.30. To protect that position, you would place a forex strike option at 1.29.

This means that if the EUR/USD falls to 1.29 within the time specified for your option, you get paid out on that option. How much you get paid depends on market conditions when you buy the option and the size of the option. If the EUR/USD does not reach that price in the specified time, you lose only the purchase price of the option. The farther away from the market price your option at the time of purchase, the bigger the payout will be if the price is hit within the specified time.

Reasons to Hedge

The main reason that you want to use hedging on your trades is to limit risk. Hedging can be a bigger part of your trading plan if done carefully. It should only be used by experienced traders that understand market swings and timing. Playing with hedging without adequate trading experience could reduce your account balance to zero in no time at all.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.