Hedging Meaning in Forex & Forex Trading Hedging Strategies
Apr 18 2025
Forex trading is a valuable skill that many people take as a full-time job. It gives freedom and control over earnings, but traders must take care to manage risk effectively. Otherwise, losses can quickly overshadow successful trades and shake their confidence.
Hedging in forex is a risk-reduction strategy that traders can leverage to reduce risk and mitigate losses by taking two or more positions contrary to each other. Although the strategy lowers potential profits, it can help traders preserve capital and stay in profit over extended periods. Let's learn more.
The Forex Hedging Strategy Explained
So, what is hedging in forex? It's a risk-offsetting strategy in which traders open multiple positions to counterbalance one another and reduce the impact of adverse exchange rate movements. Several types of forex hedging strategies exist, so there are techniques for everyone.
The purpose of hedging is to offset risk, not increase earnings. As such, it will reduce potential trading profits. People learning about hedging's meaning in forex often assume they'll end up with zero net profit as each trade cancels the other out. However, this isn't the case.
Forex pairs are seldom perfectly correlated, so traders typically use partial hedging or purchase an options contract to offset losses. These approaches ensure some profit is left on the table while drastically reducing potential adverse effects.
Hedging in forex is especially critical when trading volatile assets. It can be hard to predict a pair's direction, and sudden, significant moves that would result in substantial losses are typical. Therefore, hedging is a valuable tool that protects traders and reduces downside risk.
How Does Hedging Work in Forex
As we briefly mentioned, traders can utilise many hedging methods, each having unique pros and cons. Ultimately, the best forex trading strategy will depend on your goals, preferences, and the particular trading methods you utilise. Some popular forex trading hedging strategies are:
Direct Hedging
It can be challenging to find different forex pairs with 100% correlation. Thousands of factors influence the value of currencies, and some are nation-specific. This is where direct hedging comes into play. Instead of taking a position in a correlated asset, traders take two positions on the same asset.
For example, a USD/JPY trader might expect short-term volatility and be worried it will push their position down a lot. If they have taken a long (buy) position, they might also take a short (sell) position at 70% of the primary position's value.
In this forex hedging example, the trader covers themselves against potential instability with the short, which can be closed after the volatile period elapses. In doing so, the trader lowers risk but leaves 30% of their profit on the table if the trade goes to plan, making it a solid way to trade forex for beginners.
Correlation Hedging
Sometimes, it can be more effective to spread risk between multiple forex pairs than to hedge directly on a single asset. In these instances, correlated hedging is used. It requires traders to find two or more pairs that move in positive or negative coordination with each other.
It can be challenging to find currencies which respect each other's movements. An example of correlation forex hedging would be taking a long in GBP/USD and shorting EUR/USD because the Euro and Great British Pound typically move in similar ways against the US Dollar.
Options Hedging
An options contract entitles you to buy an asset at a specific price by a particular time, but the contract holder isn't forced to exercise their option. Direct or correlated hedging can substantially erode profits. However, hedging forex with options enables people to offset risk without opening multiple positions.
People wondering how to hedge in forex with options can purchase a put (sell) option if they have a long position in, say, NZD/USD. It lets the trader sell NZD at a given price, regardless if it falls below that level. If the trade rises in value, the option is left to expire, so the trader loses only the premium fee.
Forward Contracts
What does forward contract hedging mean in forex? The concept is very similar to options hedging, with a couple of key differences. Forward contracts are agreements between two parties to buy or sell an asset at a specific price. However, unlike options, both parties are obligated to carry out the trade.
Benefits and Risks of Forex Trading Hedging Strategies
While hedging is an effective technique that many traders leverage, it's not perfect.
Some notable benefits of hedging in forex include:
- Reduced risk: Hedging minimises the impact of a lost trade, helping people stay within their personal risk tolerance.
- Capital preservation: People can mitigate losses with hedging, helping them to have more funds available for the future when the market could offer better opportunities.
- Volatility protection: Sudden, unexpected price movements lead to lost trades. Hedging forex positions offers traders protection against these types of rapid changes.
However, hedging forex isn't infallible. Some important considerations when employing the strategy include:
- Lower profits: Although hedging is effective at reducing risk, it also reduces potential earnings, as traders must cover both positions.
- Increased costs: Even methods like options hedging, which doesn't require opening a second position, involve additional costs (for example, options premiums), raising total trading costs.
How To Hedge in Forex With Examples
People learning how to hedge in forex need to be aware of the types of scenarios in which the technique is effective. Generally, hedging best suits situations in which volatility could occur, such as significant news announcements, economic data releases, or geopolitical events such as sanctions.
A few forex hedging examples include:
Say a trader holds a EUR/USD position, and US Inflation data is about to be released. If the data doesn't match expectations, the EUR to USD exchange rate could rise. Therefore, they might purchase a put option entitling them to sell USD at a higher price, covering them in case of a drop.
When a trader has a position in a forex pair like GBP/USD and knows an event like the Brexit referendum is going to take place, they might directly hedge by taking a GBP/USD short or use correlation hedging by taking a position in the EUR/USD pair, which follows GBP/USD.
Tips for an Effective Forex Hedging Strategy
Hedging is excellent for reducing risk and preserving capital to help traders stay in the game longer. We've curated a few valuable tips for a successful forex hedging strategy.
Traders should closely monitor the market to identify when it's appropriate to hedge against their forex signals. Generally, hedging is best suited to periods of uncertainty or volatility, like when traders expect a significant news event.
Hedging a position isn't always worthwhile. As such, it's essential to weigh the benefits and cons of doing so, ensuring potential profits are still reasonable and costs are not too high. It can be helpful to keep a trading journal to keep track of any hedges and how they performed to apply to future trades.
While the concept is relatively straightforward, hedging can be challenging to get right. It's difficult as traders must account for fees, profits/losses, and premiums across multiple interlinked positions. As such, it's useful for traders to practice hedging on a demo account, allowing them to learn without risk.
How STIC Cashback Supports Hedging
After learning what hedging is in forex, traders will need to select a reputable broker. The ideal platform will have low fees, a good variety of forex pairs, ample charting tools, and multiple deposit/withdrawal options.
Finding the right trading platform can be time-consuming. However, STIC Cashback's promotion offers rebates for registering and verifying an account with any of its 16 partner brokers. Some platforms providing a registration reward include FXGT and FinPros, which offer low fees and many features.
The rebate can be used to offset spread or commission fees, which quickly add up when using forex trading hedging strategies and opening multiple positions.
Forex Hedging Trading Strategies FAQs
Is Hedging Forex Legal?
While most countries allow it, hedging in forex can be illegal, depending on where you reside. For example, the United States Commodity Futures Trading Commission (CFTC) banned forex hedging in 2009. However, the practice is legal in the EU, Asia, and Australia.
What Is Hedging in Forex?
Hedging in forex involves taking two or more positions to counterbalance a trade in order to reduce risk and combat volatility. Multiple forex hedging strategies exist, like options, direct, or correlated hedging.
What Is an Example of Hedging in Forex?
An example of hedging in forex would be when a trader longs the GBP/USD pair and shorts the EUR/USD pair. This strategy covers the trader if the US dollar devalues against GBP as the Euro closely follows the pound's moves against USD.