What are the best Forex hedging strategies?

8 min read

Hedging in the world of investing helps to reduce risks. Hedging works like an insurance policy. And the methods used vary across various asset classes. For instance, investing in gold and precious metals is often viewed as a good hedge against inflation due to the brilliant historic performance of the asset class in times of high inflation. When it comes to trading stocks, investors hedge their risks by acquiring stock options. Hedging in general is a complex risk management process that is utilized by a few portion of traders. 

Hedging in Forex can be very beneficial for some position traders. As complex as it might sound, the idea is simple and there’s nothing too difficult about it. To get a clearer picture, let’s discuss a simple example: Let’s say, you are shorting EUR/USD and intend to stay in the position for weeks or months. And you are unsure about how certain market news can affect your trade. Instead of closing your position, by opening a short term order in the opposite direction, you are hedging your risks against that particular news. Hedging usually occurs shortly, in response to certain challenges.

There’re various Forex hedging strategies and in this article we’ll talk about the best ones:

  • Direct FX hedging Strategy 
  • FX Correlation hedging strategy
  • FX Options trading strategy

Trading these strategies involves opening a new trade or several trades in the opposite direction to your original one. Each strategy has its strengths and weaknesses. Let’s discuss each one of them in more detail.

Direct FX hedging Strategy 

Direct hedging in Forex occurs when traders are already in trade and open the opposite trading orders on the same pair. The strategy is utilized by traders who are not sure on how certain events can influence the pair price and want to stay in the position longer. On the downside, if the news is positive for the original order, the trader experiences losses from the hedged position. In order to limit the losses, it’s wise to use the stop loss order on hedged positions. The size of your stop loss depends on the environment, the importance of the news and other factors. 

It’s important to note that some brokers do not allow direct hedging and they close out the first position whenever you place an opposite one or merge them. Direct hedging in Forex trading is not allowed in some countries, including the USA. The main reason why American financial authorities have decided to ban the practice is to keep the traders from overtrading and paying double spreads and commissions. 

FX Correlation hedging strategy

Some Forex pairs are in close correlation with each other. The correlation is calculated using the correlation coefficient ranging from -1 and +1. The proximity to +1 indicates that the currencies will move similarly on the charts. (based on historical data) The proximity to -1 means that the currencies are correlated adversely. If the coefficient indicates a number close to 0, it means that the currencies are not correlated.

The Forex Correlation hedging strategy involves opening the opposite position to your original position using a closely correlated currency pair. For example, Euro and GBP are widely known to be closely correlated due to the fact that both European and British economies have close ties. In case you’re planning to hedge your risks when trading EUR/USD, you can open an opposite order on GBP/USD. 

On the upside, the correlation strategy is completely legal in all countries and often utilized by Forex traders. 

On the downside, no currency is in complete correlation with another. As a result risks are magnified during divergence. 

Moreover, correlation hedging strategies can also be used in stock markets, when many shares copy the performance of their index, while the index measures the collective performance of certain shares. 

FX Options trading strategy

In case you want to avoid opening and closing multiple trades in opposite directions on the same currency at the same time, you can use options. Options give traders a right and not an obligation to purchase or sell currencies at a predetermined price, at a specific date into the future. 

Forex options are preferred by many traders due to the fact that the risks are limited. On the downside, traders pay the premium for opening the position. 

Now let’s see the example, let’s say a trader has opened a long position on EUR/USD from 1.07 and everything goes according to the plan. And the price of the pair has jumped to 1.1. In order to protect the position from possible losses, the trader can buy a put option at 1.09. So that even if something unexpected happens, a trader can exercise the option and close position at 1.09, limiting further losses.

Risks associated with hedging in Forex

The biggest risk that comes with hedging is its complexity. The idea is simple. However, execution is very hard. As smoothly executing the trading strategies requires careful planning, timing entries and exits and  weighing the costs and benefits.

Another risk to consider is associated with discipline. Placing multiple orders on the same currency pair can easily turn into revenge trading. Traders who cannot manage their emotions often double their positions after experiencing a loss. Hedging almost guarantees that one of your positions will be in minus since they are placed towards different directions. If you find it hard to take a loss, you should avoid trading in general. Doubling down the position sizes after a losing trade is not trading. It’s gambling. 

The increased number of trades means that you’re charged with more spreads and commissions.

At the end of the day, you should ask yourself, is hedging worth all of the headaches when you can simply close the trade whenever you’re unsure about the market news? Depends on your preference, but it’s definitely worth knowing how these strategies work. The more you know, the better.  

When should you hedge in Forex?

You should avoid hedging in Forex unless you understand how hedging works. Learn as much as you can about positively and negatively correlated pairs before starting investing in Forex. Moreover, to be able to directly hedge your trades, you should make sure your broker allows such practices. 

Hedging is a good idea when traders are worrying about the market reaction on particular events and want to stay in the positions longer. 

You should avoid hedging in Forex if it’s too difficult for you and you don’t want to pay extra charges on spreads, commissions or premiums.

FAQs on Forex hedging strategies

What is hedging in Forex?

Hedging in Forex means that traders open opposite orders to their original order directly or indirectly in an attempt to reduce exposure to certain market conditions.

What are downsides of hedging?

There are various downsides in Forex hedging. Direct hedging is banned in some countries. Hedging is complex and requires experience and careful planning. Hedging provides additional fees such as spreads and commissions on new positions. Hedging can cause novice traders to over trade.

Is hedging difficult?

Yes. Hedging requires careful planning, weighing the costs and benefits and timely execution. All of which are complex and very few Forex traders hedge their risks. 

Is it important to learn about hedging strategies?

It’s important to learn as much as you can. No one strategy fits a single trader. By testing out various strategies and understanding the way other investors trade, you’ll expand your chances in the financial markets.

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