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Beginner Tips to Use a Forex Hedging Strategy

Forex hedging introduces the approach of opening multiple positions simultaneously. Traders use this technique to offset Forex trading risk, as the FX market is often affected by a variety of adverse conditions, especially during market uncertainty.

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This is why investors seek extra tools to protect open positions by purchasing or selling extra assets to minimize the risk of potential exposure. In this article, we will explain how Forex exchange hedging works. Additionally, we will revise some major FX hedging strategies.

What Is Forex Hedging?

The idea of any Forex hedging strategy relies on opening one or several positions to oppose the direction of the current trend. It lets traders achieve a net-zero balance or get as close to it as possible. Generally, most investors would rather close a position and re-enter the market under more favorable conditions. Forex hedging makes it possible to leave the first position open while making another move simultaneously.

In simpler words, the approach makes it possible to protect open positions of an underlying currency pair against potentially negative market moves. Traders must always track different events and news that may result in extreme FX volatility. This awareness can be the fundamental aspect of building effective short-term protection.

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Forex hedging comes in two similar approaches:

  1. Traders can open opposite positions in the same asset (currency pair).
  2. The second way is to buy FX options.

The first method looks more flexible and more predictable in terms of risk management. It has proved to be better protection in case of markets moving against you.

Types of Forex Exchange Hedging

Now, let’s have a closer look at types of Forex exchange hedging and how they work. We can divide all major FX hedging strategies into two major categories.

Direct Hedging

Depending on the online Forex broker, traders are likely to have a chance and place direct hedge transactions. It means you are allowed to place several deals using a single asset, for example, USD/GBP. What’s more, you will probably be able to go short on the same currency pair simultaneously.

As a result, you will have zero net profit. However, if you have the tools to time the FX market accurately, you can make some profit without the extra risk involved.

Complex Hedging

A complex methodology offers to choose two assets that correlate in the most favorable manner. For example, major currency pairs such as EUR/USD and GBP/USD might be a good combination. The next step is to take positions in opposite directions for both currency pairs. If one of any currencies declines, you will still compensate for losses with a short position.

The most challenging part here is to accurately close positions no matter if you apply a direct or complex Forex hedging strategy. If you decide to keep the first position open, you must close the second one. If you are eager to close the hedge from both ends, it is vital to take action simultaneously. Otherwise, you will lose due to a sudden gap.

So, to ensure proper strategy execution, you need to find the perfect moment to close the position. If a trader overlooks any of his or her open positions, the entire Forex hedging strategy will be doomed to failure.

Now, it is time we reviewed some of the most popular FX hedging strategies. We will discuss 3 major options that are popular with investors:

  • Forward Currency Contracts – a financial derivative that relies on the contractual agreement between sellers and buyers. They agree on currency exchange at a future date. A buyer is obliged to purchase the asset. While the contract may have either delivery or cash basis to be fulfilled at any point throughout the agreement. Besides, the approach delivers more freedom for customization, as the expiration date can be changed, though the currency must be traded exactly at a determined volume. Investors generally prefer this technique of derivative trading, as it comes with lower risk, especially when it comes to the Forex market and currency trading. By the way, a similar approach can be applied when trading currency futures. The process is identical.
  • Cross currency swap hedge – the strategy introduces a type of interest-rate derivative product. With two different counterparties engaging. They involve either businesses or individual investors who agree on the interest payments and exchange conditions (principals). The agreement applies to assets in the form of separate currencies. The approach does not involve trading on a centralized foreign exchange market. It means the agreement can be changed or customized, as rates can fluctuate while reacting to FX market moves. The main idea of a cross-currency swap hedge is to minimize the risk of the inflated currency rate.
  • Forex hedging with options - FX options refer to another type of derivative product. The only difference here is that both parties are not obliged to buy or sell the asset, even if the contract date expires. Generally, they introduce a form of short-term FX hedging strategy that does not have a specific expiration date and may expire at any time.

The Bottom Line

Forex hedging is mainly used to lock the price of an asset in an agreement between a buyer and seller. It helps to protect traders from markets moving against them. Market participants can choose from several FX strategies and approaches with fixed buy and sell obligations or less compulsory conditions with a chance to customize the contract.

The main benefit of the approach is the ability to keep one protected from economic recessions or survive during a bearish market.

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.