How to hedge forex positions

What is hedging in forex?

Hedging in forex is the act of strategically opening additional positions to protect against adverse movements in the foreign exchange market.

It’s the process of buying or selling financial instruments to offset or balance current positions to reduce the risk of exposure. Most traders and investors will find ways to limit the potential risk attached to the exposure, and hedging is just one strategy they can use.

An example of hedging would be to minimise foreign exchange risk. Let’s look at an example to explain this:

You own a house in the US that you plan to sell. You fear that, following a surprise US election result, the USD will weaken against the SGD, thereby making your property’s value drop.

To hedge your risk, you take a long position on SGD/USD. This means you buy the Singapore dollar and sell the US dollar.

If SGD strengthens, you’ll make a profit on your CFD (contract for difference) trade and mitigate some of the ‘loss’ on the property. If the USD strengthens, you’ll lose your trade, but the higher value of your property (due to the favourable exchange rate) will offset some of this loss.

Why should you hedge in forex trading?

You might hedge forex to protect yourself against exchange rate fluctuations. While there’s no sure-fire way to remove risk entirely, the benefit of using a hedging strategy is that it can help mitigate loss – or limit it to a known amount.

Currency hedging is slightly different to hedging other markets, as the forex market itself is inherently volatile. While some forex traders might decide against hedging their forex positions – believing that volatility is just part of trading FX – it boils down to how much currency risk you’re willing to accept.

If you think that a forex pair is about to decline in value, but the trend will eventually reverse, then hedging can help reduce short-term losses while protecting your longer-term profits.

3 forex hedging strategies

There’s a vast range of risk management strategies that forex traders can implement to take control of their potential losses, and hedging is among the most popular. Common hedging strategies include simple forex hedging, or more complex systems involving multiple currencies and financial derivatives, such as options.

Perfect hedge (simple forex hedging strategy)

One forex hedging strategy is called the perfect hedge, also known as a simple forex hedging strategy. It involves opening the opposing position to a current trade. For example, if you already had a long position on a currency pair like EUR/USD, you might choose to open a short position on the same currency pair.

Though the net profit of a direct hedge like this is zero, you’d keep your original position on the market ready for when the trend reverses. If you didn’t hedge the position, closing your trade would mean accepting any loss, but if you decided to hedge, it would enable you to make money with a second trade as the market moves against your first.

Some providers don’t offer the opportunity for direct hedges and would simply net off the two positions. With us, the force-open option on our platform enables you to trade in the opposite direction from your initial trade, keeping both positions on the market.

Multiple currencies hedging strategy

Another common FX hedging strategy involves selecting two currency pairs that are positively correlated, such as GBP/USD and EUR/USD, and then taking positions on both pairs but in the opposite direction.

For example, say you’ve taken a short position on EUR/USD, but decide to hedge your USD exposure by opening a long position on GBP/USD. If the euro did fall against the dollar, your long position on GBP/USD would have taken a loss, but it would be mitigated by profit to your EUR/USD position. If the US dollar fell, your hedge would offset any loss to your short position.

It's important to keep in mind that hedging more than one currency pair does come with its own risks. In the above example, although you'd have hedged your exposure to the dollar, you'd have also opened yourself up to a short exposure on the pound, and a long exposure to the euro.

If your hedging strategy works, then your risk is reduced and you might even make a profit. With a direct hedge, you would have a net balance of zero, but with a multiple currency strategy there is the possibility that one position might generate more profit than the other position makes in loss.

But if it doesn’t work, you might face the possibility of losses from multiple positions.

Imperfect hedge (forex option hedging strategy)

When using the imperfect hedge, you’re essentially employing an options hedging strategy. A currency option gives the holder the right, but not the obligation, to exchange a currency pair at a given price before a set time of expiry.

There are two kinds of options – a call (buy) and a put (sell). You can buy or sell a call option, as well as buy or sell a put option. Options are extremely popular hedging tools, as they give you the chance to reduce your exposure while only paying for the cost of the option.

Let’s say you’re long on AUD/USD, having opened your position at $0.76. However, you’re expecting a sharp decline and decide to hedge your risk with a put option at $0.75 with a one-month expiry.

If – at the time of expiry – the price falls below $0.75, you’d have made a loss on your long position but your option would be in the money and balance your exposure. If AUD/USD had risen instead, you could let your option expire and would only pay the premium.

Hedge your FX positions via options trading with us

How to hedge in forex trading

1. Create a live or demo CFD trading account to practise your strategy
2. Research the currency pairs you want to trade
3. Learn about hedging if you’re not familiar with it
4. Determine the hedging strategy you want to implement
5. Take your CFD trading positions and monitor them

Forex hedging summed up

• Forex hedging is the practice of strategically opening new positions in the forex market, as a way to reduce exposure to currency risk
• Some forex traders don’t hedge, as they believe volatility is part of the experience of trading forex
• There are three popular hedging strategies: simple forex hedging, multiple currencies hedging and forex options hedging
• Before you start to hedge forex, it’s important to understand the FX market, choose your currency pairs and consider how much capital you have available
• It’s a good idea to test your hedging strategy on a demo CFD trading account before you trade on live markets