Investing > Hedging Forex Explained

Hedging Forex Explained

Hedging your forex trades can lower your risk - if you learn how to do it right.

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Updated March 09, 2021

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Do you like losing money on a trade?

Of course not—no one does. But sometimes, you need to hang onto a position that you know might take a downturn. 📉

Whether it’s because of general market fluctuations or a major piece of economic news, everyone’s forex positions are in danger at some point. In those cases where you can see a downturn coming, you want a strategy that can mitigate your losses and keep you in the green. 

With forex trading at all-time highs and organizations like CME Group seeing 50% increased retail participation, you’re certainly not alone in searching for strategies to safeguard against the volatility of the forex market. Many traders turn to forex hedging as a way to balance their portfolios and prevent losses. 

This guide will walk you through everything you need to know about hedging forex: what it is, why and how to do it, various strategies, and the risks that it presents. By the end of this article, you’ll be able to decide whether hedging forex is the right move for your investment style. 

What you’ll learn
  • What Exactly is Hedging?
  • Benefits of Hedging in Forex
  • The 'Perfect Hedge' Explained
  • What's an 'Imperfect Hedge'?
  • Forex Hedge and Hold
  • Exiting a Hedge
  • The Legalities of Forex Hedging
  • The Risks of Hedging in Forex
  • Conclusion
  • Forex Hedging: FAQs

What is Hedging in Forex? 👇

Hedging moves past beginniner forex trading into more sophisticated ways to reduce your risk. Imagine you have a position that you believe may soon take a downturn due to an event in the market. 

You secure a second position that you expect to have a negative correlation with your first position—that is, when your existing position goes down, this second position will go up. This mitigates your risk, and we know that, often times, lower risk creates higher rewards in the long run—especially in the highly volatile market we have today.

This is called forex hedging, and as you can see the gains from your second position will offset the expected losses from your first position. This allows you to maintain your first position while still reducing your losses. The two positions should be the same size in order to zero out your losses. Of course, this also means that you will zero out your gains while you hold both positions.

Hedging is one of many strategies for trading forex that can help you manage downturns in the market or in your specific positions. Hedging is most useful when you can see a downturn coming but don’t want to give up your position. That might be because you suspect your assets have been over-purchased, or you see political and economic instability in the region of your currency.

The Benefits of Hedging in Forex ✅

Economic news and political choices can make an impact on open positions. For example, Bitcoin has been setting record highs after it was endorsed by Elon Musk and Tesla. If you have held a position for a long time and do not want to sell it, hedging can be an option to protect against short-term losses created by these situations. 

Let’s take an example. Say you hold USD/JPY, and it is undergoing a consolidation period that could lead to big gains or big losses. If you hold an open position in this pair and suspect the price may decline further than the resistance line, you can hedge with another position that might rebound to previous highs. 

USDJPY Consolidation Period example
USD/JPY consolidation period example. Image by TradingView.

Now, if the price of USD/JPY drops significantly, you will be able to close both of your positions, which will reflect your earnings from the previous price changes before the downturn. On the other hand, if the USD/JPY price point increases, you can close your second (hedged) position in order to collect the profits from this upswing. 

Make sure to keep an eye on your trades so that you do not end up missing out on potential profits. Remember, just as hedging mitigates losses, it also cancels out profits. This strategy protects you against short-term market volatility, and is geared more toward preventing loss than creating large gains. When you see news such as the Central Bank of Israel purchasing $30 million in forex, assess your positions to determine whether hedging might protect you from resulting market volatility. 

Perfect Hedge Explained 📈

There are two primary strategies for how to hedge in the forex market. The first is called a “perfect hedge,” as it eliminates risk (and profit) entirely from your position. A perfect hedge refers to an investor holding both a short and long position on the same pair at the same time. 

These two positions then offset each other, canceling all losses or gains. Usually, a trader will do this because they hold one position as a long-term trade, so they open a contrary position to offset short-term market volatility due to news or events. 

It’s important to note that this kind of hedging is not allowed in the United States, and you should generally be familiar with U.S. forex regulations. The opening of a contrary position is regarded as an order to close the first position, so the two positions are netted out. However, this results in roughly the same situation as the hedged trade would have. 

For example, let’s look at this NOK/JPY chart. Say you open your position just before the price jumps.

You could close out your position when the pair reaches a new peak, but you may want to keep it open and see what happens next. In this case, you could open a contrary position in case the pair takes another nosedive—this would allow you to keep your profits from the initial gain. The hedge would thus safeguard your profits while you wait for more information about how the pair will perform. 

This image shows an upward trend in the price of the NOK/JPY currency pair.
NOK/JPY upward trend. Image by TradingView.

This can also be a strong strategy when a pair is particularly volatile. For example, EUR/USD has been setting high highs and lows as the confidence in the dollar swings back and forth. 

What is an Imperfect Hedge? 💡

You may not be able to open a position that completely cancels the risk of your existing position. Instead, you may create an “imperfect hedge,” which partially protects your position. You can buy options to reduce the risk of a potential downside or upside, depending on which way you believe your pair may be going. 

Imperfect Upside Risk Hedging

If you suspect your pair may increase in price, a call option can help you manage risk. A call option allows you to buy a currency pair at a set price (called the strike price) before a set date (called the expiration date). You are not required to buy the pair, but you are able to at any time before the expiration date.  However, you must pay an upfront premium for a call option. 

For example, say you short EUR/USD at 1.3225, and there is upcoming news that may cause it to decrease or increase. You could then buy a call option for a higher price such as 1.3275 with an expiration date after the big announcement. 

If your pair does not increase after the announcement, you do not have to exercise your call option, and can profit from the downturn in the pair. Your only loss would be the premium paid for the call option after it expires. 

However, if your pair does increase after the announcement, then your only risk is the gap between your initial value and the strike price (1.3225 – 1.3275 = 0.0050). No matter how high it goes, you are able to purchase at this price. Your loss is then 50 pips plus the premium for the call option, which may be significantly less than a major turn in the pair would have cost you. 

Imperfect Downside Risk Hedging

If you suspect your pair may go down in price, you may want to purchase a put option contract. Put option contracts allow you to sell a pair at a certain price, called the strike price. This must be done before a certain date, called the expiration date. You are not required to sell at the strike price—if you do not sell before the expiration date, you will simply not be able to sell at the strike price anymore. Put option contracts are sold for an upfront premium. 

For example, say you hold EUR/JPY at 1.4575, and you are concerned it may lose value due to an upcoming political announcement that may affect one or both economies. You could buy a put option contract with a strike price lower than the current rate—say 1.4550. Be sure to set the expiration date for after the announcement. 

Say the announcement happens, and EUR/JPY maintains its same price or even increases. In this case, you are not obligated by the put option contract, and could even benefit from profits that it sees. Your only loss in this case is the premium paid for the contract. 

On the other hand, say the announcement happens, and EUR/JPY decreases. Now, your risk will be mitigated, because no matter how low it goes, you will be able to sell for 1.4550 before the expiration date. Your loss is thus the premium paid for the contract, plus the difference in the original value and the strike price (1.4575 – 1.4550 = 0.0025). This is true no matter how much your pair decreases. 

Forex Hedge and Hold 🤝

Hedge and Hold is an additional strategy that refers to taking an additional position that counteracts your higher-risk existing positions. For example, say you have the following positions: 

  • Short CAD/GBP 
  • Short USD/JPY
  • Long GBP/JPY

Let’s also say that you are concerned about GBP dropping due to upcoming economic or political news, but you don’t want to close out your positions. Instead, you can purchase an additional position selling GBP/USD. This means that you are selling pounds and buying dollars, which reduces your exposure to GBP. Since you are short USD, this offsets your other positions well. 

Hedge and hold requires you to offset your short and long positions in your existing assets. In the above example, your exposure to USD increases, which you may not want based on your understanding of how the market will move. 

You may also want to place trades with correlated currency pairs. Many pairs are inversely related to each other. By consulting a live matrix, you can select a pair that will be market neutral and protect your positions. However, since pairs are generally not 100% correlated, note that this will also offer a partial protection. 

EUR/USDUSD/JPYGBP/USDAUD/USDUSD/CADUSD/CHFNZD/USD[DAX30][DJI30]
EUR/USDN/A+8+7-64+10-97+5+20-80
USD/JPY+8N/A-53-69+74-13-65+66-6
GBP/USD+7-53N/A+24-83-12+49-71-28
AUD/USD-64-69+24N/A-56+68+52-27+65
USD/CAD+10+74-83-56N/A-8-68+62+6
USD/CHF-97-13-12+68-8N/A-5+3+89
NZD/USD+5-65+49+52-68-5N/A-5-23
[DAX30]+20+66-71-27+62+3-5N/A+94
[DJI30]-80-6-28+65+6+89-23+94N/A

Exiting a Hedge 🏃‍♂️💨

Many people are turning to forex trading during lockdown, and it can make for a strong investment strategy. Moreover, risky currency pairs are becoming more profitable, and traders who want a piece of this volatile pie need to hedge well—but also know when to de-hedge.

 Hedging can help many individuals mitigate their risk, but it is not a permanent strategy. When the risk has passed, it’s time to close out your hedge position. You may fully remove your hedge in a single trade, or partially reduce it. 

When to De-Hedge ⌚️

There are many reasons you may want to exit your hedge. Your hedge may have paid off—if the position did indeed take a major downturn, you may be closing the initial position and the hedge in order to collect the profits the hedge maintained. 

You may also determine that the market risk has passed. In this case, removing the hedge allows you to collect the full profits of your successful trade. Finally, you may want to remove your hedge in order to lower the costs of hedging.

How to De-Hedge ⚙️

Exiting a hedge requires you only to close out your second position. Do not close out your initial position that was protected by the hedge (unless changes in the market have made you determine this is the best course of action). If you are closing out both sides, make sure to do so simultaneously to avoid any losses that may occur in the intervening time. 

Make sure you track your hedged positions so that you can close out the right positions when you deem it best to do so. Leaving a position open can damage your entire strategy. And remember, since the forex market operates 24 hours per day, you’ll want to make your forex trades at the best times.

Is Forex Hedging Legal? 👨‍⚖️

It is not legal to buy and sell the same strike currency pair at the same or different strike prices in the United States. It is also not permitted to hold short and long positions of the same currency pair in the U.S. However, many global brokers allow forex hedging, including the top UK forex brokers and even many of the top Australian forex brokers.

Can Hedging Be Risky? ⚖️

All forex trading involves risk, and hedging is no exception. A bad hedging strategy or execution can create more risk than it mitigates. 

Hedging is complicated, and this means that one can’t be certain their trades will counteract losses. Even experienced traders can see both sides of their positions take a loss. Commissions and premiums can also cut into profits or magnify losses. 

Don’t start hedging until you have a solid understanding of the market and how it fluctuates. Without significant market experience, accurate market forecasts, and a good deal of patience, your hedges are not likely to help you.

Hedging is not a magic wand and often takes time to pay off. Be careful not to spin out of control on your open positions if you feel the need to hedge your hedged positions and end up with too many layers. 

Conclusion

Hedging is a complex strategy that can help experienced traders mitigate their losses and reduce risk in volatile market situations. It is particularly useful when you expect short-term volatility due to political news or economic events in the regions of your pairs. Be sure to stay on top of economic and political news that could affect your currency pairs, such as strong retail sales in the U.S. bolstering the dollar

When you sense an increase in risk but do not want to close out your position, hedging can be a good way to buy yourself more time to see how the market plays out. Make sure that you have the experience and forecasting accuracy needed to make good, intentional hedged trades. 

Forex Hedging: FAQs

  • Which Forex Brokers Allow Hedging?

    Brokers in the UK, Australia, Asia, Europe, and South America often allow hedging. Usually, the only brokers that don’t are based in the U.S. 

  • Is Hedging in Forex Illegal?

    Some types of hedging in forex are illegal in the United States, including holding long and short positions of the same pair. However, forex hedging is not illegal in many other countries. 

  • How Do You Make Money from Hedging in Forex?

    Hedging allows you to keep a trade active even when it has greater risk. Rather than bringing in high rewards, hedging is intended to prevent major losses.

  • Why is Hedging Not Allowed in the U.S.?

    The U.S. banned hedging in 2009 because it eliminates opportunity to profit on the transaction and has a high potential for abuse.

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Fees
Average spread EUR/USD standard

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Minimum initial deposit

$0

€100

General
Total currency pairs

105

50

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Rating
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Average spread EUR/USD standard

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0.75

All-in cost EUR/USD - active

N/A

N/A

Minimum initial deposit

€100

$50

General
Total currency pairs

50

47

Demo account?
Social / copy trading?
Rating
Fees

Average spread EUR/USD standard

N/A

Varies

0.75

All-in cost EUR/USD - active

N/A

N/A

N/A

Minimum initial deposit

$0

€100

$50

General

Total currency pairs

105

50

47

Demo account?

Social / copy trading?

All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.

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