When a currency trader enters into a trade with the intent of protecting an existing or anticipated position from an unwanted move in the foreign currency exchange rates, they can be said to have entered into a forex hedge. By utilizing a forex hedge properly, a trader that is long(buy) a foreign currency pair, can protect themselves from downside risk; while the trader that is short(sell) a foreign currency pair, can protect against upside risk.
Forex hedging strategy
A forex hedging strategy is developed in four parts, including an analysis of the forex trader’s risk exposure, risk tolerance and preference of strategy. These components make up the forex hedge:
- Analyze risk: The trader must identify what types of risk (s)he is taking in the current or proposed position. From there, the trader must identify what the implications could be of taking on this risk un-hedged, and determine whether the risk is high or low in the current forex currency market.
- Determine risk tolerance: In this step, the trader uses their own risk tolerance levels, to determine how much of the position’s risk needs to be hedged. No trade will ever have zero risk; it is up to the trader to determine the level of risk they are willing to take, and how much they are willing to pay to remove the excess risks.
- Determine forex hedging strategy: If using foreign currency options to hedge the risk of the currency trade, the trader must determine which strategy is the most cost effective.
- Implement and monitor the strategy: By making sure that the strategy works the way it should, risk will stay minimized.
The forex currency trading market is a risky one, and hedging is just one way that a trader can help to minimize the amount of risk they take on. So much of being a trader is money and risk management, that having another tool like hedging in the arsenal is incredibly useful.
Not all retail forex brokers allow for hedging within their platforms. Be sure to research fully the broker you use before beginning to trade.