What is Hedging in Forex and How to Use it Strategically

What is Hedging Forex? 

Hedging is a strategy used to protect traders against unfavorable movements in the forex market. It involves opening up more positions to reduce a trader’s risk. Forex hedging is considered short-term protection, and it’s generally utilized by traders worried about breaking news or events that could set off volatility in the currency market.  

Though hedging forex strategies are commonly associated with the forex market, they can also be implemented in other markets.  

Forex brokers also offer derivatives to hedge against currency risk. These are usually over-the-counter (OTC) products, meaning they do not trade on a centralized exchange. Sometimes, derivatives can be personalized at a certain point throughout the contract period. However, keep in mind that OTC trading is not regulated, so it’s recommended that traders do their research before deciding.  

Currency Hedging  

Another term for forex hedging is currency hedging, which occurs when market participants enter a contract where they agree to purchase or sell a specific amount of foreign currency at a pre-established exchange rate on a future date; this protects them from fluctuating rates, interest or unexpected changes that could lead to loss.  

 Forex Hedging Strategies 

Forex Options  

Forex options are a form of derivatives product that allows traders to purchase or sell a currency pair at a specific price with an expiration date set in the future. Traders do not have to purchase or sell, but forex options provide a choice. Because it expires, forex options are mainly used as a short-term strategy. Forex option prices stem from market prices of currency pairs, specifically the base currency.  

To illustrate, a trader holds a long position on JPY/USD because they believe the value will rise. In the short term, the trader wants to protect their position against a certain amount of loss, so they utilize forex options. If they take out a put option on JPY/USD, and the value falls, they’ll make money from their put option. If the value rises, they’ll lose money but profit from their long position.   

Forward Currency Contracts 

Like forex options, forward currency contracts are agreements between buyers and sellers to exchange currency at a future date. In this case, the buyer is obligated to buy the asset, but there is more flexibility for customization. At any point in the agreement, traders can settle the contract on a cash or delivery basis and change the future expiration date, the currency pair, or the volume of currency involved.  

Besides being traded on an exchange, hedging with currency futures works similarly to forwards.  

Cross Currency Swap Hedge 

This hedging strategy includes interest rates and currency risk management. Two parties, usually international businesses or investors, decide to exchange principal and interest payments in separate currencies. This strategy can be customized anytime and rarely has floating interest rates, which can change depending on the forex market.  

A cross-currency swap hedge aims to mitigate the risk of inflated interest rates. Both parties can decide on a fixed interest rate to avoid losses from volatile markets. This consideration of interest rates is where a cross-currency swap hedge differs from derivative products.  

Forex Correlation Hedging Strategy 

This strategy aims to select two positively correlated currencies and open opposite positions for them. The positive correlation indicates they are moving in the same direction. 

For instance, if USD/GBP and EUR/GBP have a positive correlation, you can hedge the trade by opening positions in both pairs by going long for USD/GBP and short for EUR/GBP. This will offset any loss incurred in either of the two currency pairs with a significant profit made on the other pair. This strategy doesn’t have to involve two currency pairs; one could be swapped for a different asset, such as gold.  

Since this is a market-neutral strategy, market fluctuations do not influence your overall positions. Instead, it balances positions that act as hedges against one another.  

How to Hedge Currency? 

Step 1  

Open an account. Start a live account to practice forex hedging techniques. If you’re unsure about hedging forex, start with a demo account for risk-free trading.  

Step 2  

Choose a currency pair. TMGM offers a wide range of currency pairs. Four common forex pairs are EUR/USD, USD/JPY, USD/GBP, and AUD/USD.  

Step 3 

Choose a strategy. Choose a strategy that best suits your needs and style, depending on your goal.  

Step 4 

Keep tabs on forex news. Since the forex market is so volatile, traders should stay updated on live updates and breaking news, as these could tremendously affect the market.  

Step 5  

Determine your entry and exit points and place a trade. Pay attention to forex signals and utilize technical indicators to build a solid technical analysis strategy.  

Step 6  

Have risk management tools in place. Stop-losses and take-profit orders should minimize losses, especially in a risky market like forex.