Whether you’re new to the world of trading or an experienced trader, hedging provides an efficient and cost-effective way to minimize market risks and offset or reduce losses. The practice of hedging became more popular with the rise of hedge funds in the last century, and an increasing number of traders and investors are using hedge strategies on a daily basis to protect their investments. Even though hedging can be fairly simple, many market participants still don’t understand how to properly hedge their positions against known market risks.

The hedging strategies are designed to minimize the risk of adverse price movement against an open trade. Through this article, we’re going to talk about a Forex hedging correlation and how to use simple trading methodolgy in a hedging strategy.

Why hedge forex?

Hedging a Forex  or foreign exchange, trade does more than just protect your open position. It sets you up to profit no matter which direction your currency pair moves. Hedging means having a buy and sell trade all together on the same securities or multiple securities that are correlated with each other and aggregating the total position value for profits or reducing the loss. Hedging can be done by opening trade on the same currency pairs at the same price or different prices also in combination with other correlated currency pairs. Sometimes, hedging is used to fix the amount of loss. It can be act like insurance policies to protect your trade against an unexpected market move. You can select a hedging strategy that protects your position in a cost-effective manner.

For example: Suppose a trader opened a buy and sell order at 1.2510. That means no matter what direction market moves, both buy and sell orders are hedged. The trader will see the commission or spread cost and swap fees. (One swap fee will be positive and one will be negative)

Hedging won’t necessarily cover the entire cost of a lost trade, however it will cover some of the loss made on a trader’s original position.

Three forex hedging strategies

There are a vast range of risk management strategies that forex traders can implement to take control of their potential loss, and hedging is among the most popular. Common strategies include simple forex hedging, or more complex systems involving multiple currencies and financial derivatives, such as options.

1. Simple forex hedging strategy

A simple forex hedging strategy involves opening the opposing position to a current trade. For example, if you already had a long position on a currency pair, you might choose to open a short position on the same currency pair – this is known as a direct hedge.

Though the net profit of a direct hedge is zero, you would keep your original position on the market ready for when the trend reverses. If you didn’t hedge the position, closing your trade would mean accepting any loss, but if you decided to hedge, it would enable you to make money with a second trade as the market moves against your first.

2. Multiple currencies hedging strategy

Another common FX hedging strategy involves selecting two currency pairs that are positively correlated, such as GBP/USD and EUR/USD, and then taking positions on both pairs but in the opposite direction.

For example, say you’ve taken a short position on EUR/USD, but decide to hedge your USD exposure by opening a long position on GBP/USD. If the euro did fall against the dollar, your long position on GBP/USD would have taken a loss, but it would be mitigated by profit to your EUR/USD position. If the US dollar fell, your hedge would offset any loss to your short position.

It is important to remember that hedging more than one currency pair does come with its own risks. In the above example, although you would have hedged your exposure to the dollar, you would have also opened yourself up to a short exposure on the pound, and a long exposure to the euro.

If your hedging strategy works then your risk is reduced and you might even make a profit. With a direct hedge, you would have a net balance of zero, but with a multiple currency strategy there is the possibility that one position might generate more profit than the other position makes in loss. But if it doesn’t work, you might face the possibility of losses from multiple positions.

3. Forex options hedging strategy

A currency option gives the holder the right, but not the obligation, to exchange a currency pair at a given price before a set time of expiry. Options are extremely popular hedging tools, as they give you the chance to reduce your exposure while only paying for the cost of the option.

Let’s say you’re long on AUD/USD, having opened your position at $0.76. However, you are expecting a sharp decline and decide to hedge your risk with a put option at $0.75 with a one-month expiry.

If – at the time of expiry – the price has fallen below $0.75, you would have made a loss on your long position but your option would be in the money and balance your exposure. If AUD/USD had risen instead, you could let your option expire and would only pay the premium.

When to Consider Hedging

Hedges are useful whenever you’re looking to maintain an open position on a pairing while offsetting some of your risk in that situation.

A short-term hedge can be a great way to protect profits when you’re unsure of certain factors that could cause volatile price movements. This uncertainty can range from a suspicion that an asset has been overbought to concerns that political or economic instability could cause certain forex pairs to plummet in value—particularly when you’ve opened a long position on those pairs.

In the USD/JPY chart shown below, a period of consolidation is creating breakout potential that could go in either direction. If you already have an open position in this currency pair and are hoping that the price decline breaks through the resistance line, you might consider hedging with another position, targeting a rebound from the trend line back up toward previous highs:

If you do open this hedge and the price breaks through the trend line, you can always close your second position and continue reaping the profits of your successful short. But if you’re wrong and the trend reverses course, you can close both positions and still cash out your earnings from the previous price change.

Traders often use hedges to protect against the short-term volatility of economic news releases or market gaps over weekends. Traders should keep in mind that as hedging reduces trading risk, it also lowers potential profits. Because of the low returns created by hedging, this strategy works best for traders who are working the forex market full-time or have an account that is large enough to generate big monetary gains through limited-percentage profits.

How to exit a Hedge trade

When you’re exiting a direct or complex hedge and keeping your initial position open, you need to close out only the second position. When you’re closing out both sides of a hedge, though, you’ll want to close these positions simultaneously, to avoid the potential losses that can come if there is a gap.

It’s important to keep track of your hedged positions so that you’re able to close out the right positions, at the right time, to complete the execution of this strategy. Overlooking one open position in the process can derail your entire hedging strategy—and potentially hit your trading account with steep losses.

Conclusion

Retail traders hedge their trades mainly for psychological reasons and not because it’s a good trading strategy. By being able to use financial hedging strategies we get the feeling that we’re not wrong about our trades, we’re just holding for a while and then we’ll take the hedge off when things are going in the direction that we know they’re going to go.

No matter which types of hedging strategies you use, you need to understand that there are no free lunches in trading. Hedging is like buying insurance against losses!

The Forex hedging strategy is a great way to minimize your exposure to risk. It not only helps you to protect against possible losses but also it can help you to make a profit.