Forex Hedging – What is Forex Hedging and should you do it?

The term forex hedging refers to the strategy of reducing the risk associated with trading in the forex market. For a beginner in market, this term may not mean much but most experienced traders use hedging as a technique to reduce the losses in cases of negative events. Forex hedging involves buying or selling of correlating currency pairs to stay protected from fluctuating exchange rates.

To understand forex hedging better, you can think of it as a car insurance policy. Though you are not completely covered when you buy a car insurance policy but a lot of expenses are covered by the insurance agency in case of an accident. Similarly, forex hedging won’t provide complete protection but reduce the losses in case of an untoward incident in the market. Forex hedging protects the long or short position of a currency pair against downside or upside risk.

Forex Hedging Strategies used by investors

Investors do forex hedging in various ways. One of the most common methods of doing this is by using derivatives. The type of derivative which the traders in forex market use is called the futures contract. In this contract, there is an agreement to buy or sell one currency for another at a specified price on a specific date. Currency futures work very similar to normal future contracts of stocks and they are a great way to hedge against currency exchange rate fluctuations.

Another strategy used by traders is by using multiple currency pairs. For example, if the traders sees that the currency pair of ‘euros-to-dollars’ is facing negative price moves, he can offset this unrealized loss by selling ‘euros-to-yen’ currency pair. The ‘long’ and ‘short’ positions for the Euro, which occur at the same time, are a hedging strategy.

The difference of interest rates also acts as a hedging tool for the forex traders. In this method, the traders open the positions of a currency pair with 2 different brokers – one which charges interest and one who does not. If the currency pair performs well, then the investor gains from both brokers. In case the currency pair does not perform so well, he gives interest to one broker while he earns the ‘rollover’ interest from the other one.

Forex hedging should not be done by an experienced investor who does not understand the swings and timings of forex market. Like, no-one can predict what will happen in stock market today, similarly, forex market is also very unpredictable especially for a beginner.

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