As a financial trader, knowing how to guard against sharp price movements should come hand in hand with knowing how to profit from them. Although many traders are familiar with when to buy and sell assets, knowing how to mitigate and prevent losses is just as important, and risk management is vital for traders who want to get better at their craft. This is where hedging comes in.
What is hedging?
Hedging is an investment made to reduce or prevent losses that may incur from unexpected market price fluctuations. In a way, hedging works like insurance, limiting risks against sharp price movements in an unfavourable direction. Frequently, but not always, a trader hedges an existing position by opening a second one, in which they bet on the reverse scenario. This is so that any losses incurred on the first position can be mitigated by profit on the second one. Hedges can be used by businesses, investors, retail traders, and other market participants. They are generally used not to make a profit but to limit risk and guard against losses. Therefore, they are usually employed on a short-term basis when a trader is worried about temporary but significant shifts in the market against their favour. In these cases, the trader may not want to close their original position as they believe the hit will pass soon. However, they do not want to take it directly and lose a lot of money either. So, for the time being, they insure their original position using a hedge until the storm passes.
How does forex hedging work?
In forex, hedging is a way for traders to protect themselves from exchange rate fluctuations in the forex market. As the largest and most liquid market in the world, dramatic currency price movements can happen instantly with the announcement of political and national news. Forex hedging, or currency hedging, is a way for forex traders to guard against these sudden movements. There are three main forex hedging strategies. They are direct hedging, cross hedging, and hedging using currency options. All three methods are commonly used as a short-term solution, and whichever one a trader uses depends on their personal preferences and knowledge of the hedging strategies themselves.
Direct hedging is opening an opposing position using the same currency pair as the one currently being traded. Currencies are always traded in pairs, meaning that a forex trader is always buying one currency and selling another at the same time. A direct hedge is thus made possible by simply reversing the existing position. A forex trader who is going long AUD/USD can create a direct hedge by opening a new position to go short AUD/USD with the same lot size. In doing this, however much AUD fluctuates, the trader will have a net balance of zero, cancelling out any losses that may incur on one position with profits on the other.
Correlated hedging involves taking two positions on two different currency pairs. The forex trader can choose any currency pairs as long as they are positively correlated. Doing so, a cross hedge is immediately created.
Hedging with currency options
A currency option is also known as a forex option, and it involves hedging with an options contract. An options contract gives the holder the right, but not the legal obligation, to go long or short on a currency pair at a given price before or on a set expiry date. This contract is obtained when the buyer of the option pays the seller a premium. A forex trader expecting a decline in the value of a currency he is buying can state a price in the options contract. This is the price at which he will be able to sell his lot and close his position, even if the currency value does depreciate. The contract will also specify an expiry date.
Hedging in forex is a helpful method for traders to guard against or minimise potential losses from sharp and unfavourable price movements. Although the primary motivation for traders who hedge is not to profit, it is a possibility. There are three main forex hedging strategies: direct hedging, cross hedging, and hedging with a currency option. As this is considered a more advanced strategy in forex trading, traders should have sufficient market experience and knowledge of forex trading instruments to minimise financial risk. Open a free demo account to familiarise yourself with various hedging strategies before placing live trades.