Hedging is a financial strategy that has applications in a wide variety of investment scenarios and can be implemented in any investment or trading situation where rapid and potentially large price fluctuations can summarily wipe out an investor’s profit from one minute to the next, such as in the trading of commodities and the trading of foreign exchange. It is the process of making offsetting investments in order to mitigate the risk of loss resulting from these rapid price changes, and is a particularly effective strategy when properly utilized in the context of retail forex trading. In forex trading, hedging involves the buying or selling of currency pairs in order to protect your position against movements in the market that are contrary to your interests and your bottom line.
In the fast-paced, highly liquid and never-closing world of forex trading, the chances that rapid decreases in the price of any specific currency can occur are particularly heightened. This is so because currency prices are influenced not only by the vagaries of the market but also by a wide variety of external factors, such as economic news, developments and announcements, whether planned or unplanned, as well as political developments, such as elections; these events impacting currency prices can occur regardless of whether you are asleep or awake (because of the continuously-open nature of the foreign currency markets), or are in front of your screen or not, and they must be hedged against—but to do so properly, you must first have a satisfactory understanding of the type and nature of such events so that you can anticipate their effects prior to their occurring, to the extent possible, and place your hedges in a timely manner. Perhaps no other trading market requires that you digest and stay abreast of as much external news and information as do the currency markets; because of this, perhaps no other trading market lends itself so naturally to the implementation of hedging strategies.
Corporations involved in international business have it easier than does the individual retail forex trader. They engage in hedging activities on a regular basis through the simple method of entering into forward contracts, in addition to any spot forex positions which they might choose to take. Under forward contracts, an agreement is entered into today to buy (or sell) a particular currency at a specific future date, however, at a price that is determined at the time that the contract is entered into. If a multinational firm having regularly-occurring financial obligations overseas (such as local salaries or rent) believes that the foreign currency will strengthen (or appreciate) against their home currency, entering into a forward contract now is a savvy way to protect themselves against anticipated increased currency costs later. Typically, however, forward contracts are not entered into by retail forex traders, whose forex trading activities are almost exclusively carried out in the spot forex market.
Hedging options available to the retail forex trader are numerous, and there are as many varied forex hedging strategies as there are opinions on their effectiveness and proper use. Which particular strategy (or combination of strategies) will prove to be optimal for your needs will depend on whether you’re a short-term, scalping player in the forex market—a true trader—or whether you’re a long term or carry trader, since each style of forex activity brings with it its own particular set of risks.
The simplest method of hedging against loss when trading forex long-term and playing the currency trends is to make good and frequent usage of trailing stops when executing your forex plays. As your chosen currency pair moves forward in your favor, your trailing stops follow, moving in parity at the level of pips which you’ve designated. If your currency pair should move against you rapidly, as can of course often happen, your trailing stop will mitigate against the loss of all of your profit; of course, the logical price for this hedge is the obvious fact that if your pair rapidly moves back up above your stop level, you’ll not be able to participate in the increased gain. For many traders, that’s a price they’re willing to pay in return for the peace of mind that comes with knowing that their losses are quantitatively limited.
Another uncomplicated and often relied-on hedging strategy involves, in essence, going both long and short in the same currencies at the same time. According to this methodology a retail forex trader trading EUR/USD will, for example, enter into a contract and set his stop loss, then enter into a second contract whose entry point is his very same stop loss point. In this way the trader knows that if his currency pair moves against him, he can wait for the market to retrace, at which point he re-enters at his former exit point—only this time, he’s moving with the market. In the best case, the implementation of this strategy will protect the trader’s long profits while supplementing those profits with the gains from his short; in the worst case, the goal is that at the end of the trading day, his gain and his loss have cancelled each other out, leading to a hopefully net unchanged capital position.
Other hedging strategies involve playing a potential decline in one currency against an anticipated gain in another, based on the theory that when one currency gains, another always loses, and vice-versa. An example of this type of hedging activity would be when a forex trader investing his capital in USD/EUR and perceiving that the market is moving against him goes long in EUR/CHF with an entry point at his original USD/EUR stop loss, because of the widespread belief that the Swiss franc and the US dollar move in inverse correlation to each other. The trader than has the choice of selling the currency which generated a net trading gain and holding the net loser until it retraces, or, if his up trade is greater than his downside, selling the loser and taking his profits from his corresponding trade. The point of the exercise is not only to hedge against the risk of loss, but in doing so, to provide the trader with additional flexibility.
If you spend some time reading up on forex hedging strategies you’ll quickly realize that there indeed are numerous methodologies of which you can avail yourself. Most often, the type of hedge that lends itself best to your particular trading style and strategy will make itself know to you as an organic by-product of the currencies in which you choose to specialize and the success you have in your trading activities. You’ll come to make decisions based on gains and losses to correct your own mistakes and reinforce your successes as you garner more experience; with hindsight, you’ll realize that the sum total of the actions you take to optimize your trading constitute a hedging strategy that’s all your own.