How is hedging done in the forex markets?

There are mainly three strategies used for hedging forex currency pairs.

Forex hedging is a key strategy that is used to protect an investors’ position in a currency pair from an adverse move. Hedging is typically a form of short-term protection when a trader is typically concerned about volatility-triggering events in currency markets.

There are mainly three strategies used for hedging forex currency pairs.

– Direct forex hedging
– Forex correlation hedging
– Use of forex options for hedging

Simple Forex Hedging

Some brokers may allow you to place trades that are direct hedges – i.e. you are allowed to place a trade that enables you to buy and sell the same currency pair, the EUR/USD pair for example. While the net profit will be zero while both trades are open, you can make more money without incurring additional risk if you time the market right and exit the losing trade.

However, the US Commodities and Securities Commission had banned this method and now brokers must square off the first position instead of having both open positions. Also, if you don’t exit the losing trade and time the market right, you will make zero money and lose some amount due to brokerage expenses and spread expenses.

Forex Correlation Hedging Strategy:

One of the most popular hedging strategies to trade in forex involves using highly positively or negatively correlated currency pairs – like the GBP/USD and GBP/JPY for example. In some cases, the degree of positive correlation between these pairs could be over 90% i.e. those two pairs move in the same direction at least 90% of the time. Taking advantage of this, traders can open long GBP/USD and short GBP/JPY positions as those pairs typically move in the same direction, the loss in one trade will very likely be countered by gains in the other one.

This hedging strategy can be utilized not only for positively correlated pairs but negatively correlated pairs as well. For example – a trader can open long positions in both AUD/USD and USD/CAD where these two tend to move in opposite directions, and therefore losses in one trade will be offset by the gains made in the other, making it a viable hedging strategy as well.

Forex Options Hedging Strategies:

Let’s suppose that a trader has opened a long EUR/USD position at 1.20. If the Euro appreciates against the US dollar, say to 1.23, the trader has made a winning trade. However, to protect their position against any potential losses, the trader can purchase EUR/USD put option at 1.19 so that he/she can exercise the option and close the position at 1.19, limiting his/her losses considerably.

Although traders have to pay premiums to purchase the option, professionals consider this approach as a cheaper alternative to other hedging strategies. If the trader makes an accurate prediction and the Euro goes up against the USD, then the gains will not be offset by a second trade like the two previously mentioned strategies. If the market does turn against the trader, the premiums would still be much smaller than the potential losses that the trader would have otherwise faced.