Investors in all walks of life use hedging as a strategy to protect a position from adverse price fluctuations. Normally, hedging involves opening a second position, which may be negatively correlated with the main asset held, which means that if the price of the main asset changes adversely, the second position will experience complementary opposite changes, thereby offsetting The loss of these adverse effects.
Understand the basics of foreign exchange hedging

In foreign exchange trading, investors can use a second pair of currencies to hedge their existing positions that they do not want to close. Although hedging reduces the risk at the expense of profits, it can be a valuable tool to protect profits and avoid losses in foreign exchange transactions.

Understand the basics of foreign exchange hedging

Foreign exchange hedging involves opening a position in one currency pair to offset possible changes in another currency pair. Assuming that these positions are of the same size and the price trend is inversely proportional, then when these positions are active, their price changes can cancel each other out.

Although this eliminates potential profits during this window, it also limits the risk of loss.

The simplest form is direct hedging, where traders open buy and sell positions on the same currency pair in order to retain any profits they have already made or to prevent any further losses. Traders may use more sophisticated hedging methods to take advantage of the known correlation between two currency pairs.

How does foreign exchange hedging work

The process of opening a foreign exchange hedge is simple. It starts with an existing open position (usually a long position) in which your initial trade is expected to move in a certain direction. Create a hedge by opening a position opposite to the expected trend of your currency pair, allowing you to maintain an open position in the original transaction. If the price trend goes against your expectations, there will be no loss.

Usually, this hedging is used to preserve the income you have already earned. The NOK/JPY chart below demonstrates situations in which traders may wish to hedge. For example, if they open a long position close to the low point of the chart and take advantage of the huge gains generated in the following days, traders can choose to open a short position to hedge any potential losses

Although traders can also simply close their positions and cash in their gains, they may be interested in keeping the open positions in order to see how the chart patterns and technical indicators change over time. In this case, when the trader maintains the position and gathers more information, hedging can be used to offset potential gains and losses. Even if the price plummets, they can cash out all the gains from the initial rise.

Create complex hedges in Forex

Since complex hedging transactions are not direct hedging transactions, more trading experience is required to effectively execute them. One method is to establish positions in two currency pairs, and their price movements are often correlated.

Traders can use the correlation matrix to identify foreign exchange pairs with a strong negative correlation, which means that when the price of one pair rises, the other pair falls.

For example, the combination of USD/Swiss franc and EUR/USD is an excellent choice for hedging due to its strong negative correlation. By opening a US dollar/Swiss franc buy position and a euro/US dollar short position, traders can hedge the US dollar position to minimize transaction risks.

Foreign exchange options trading also creates hedging opportunities, which can be effective when used in specific situations. Experienced traders need to be able to identify these small windows of opportunity, in which complex hedging can minimize risk while helping maximize profits.

When to consider hedging

Hedging is very useful when you want to maintain an open position in a pairing while offsetting some of the risks in this situation.

When you are not sure that certain factors may cause price fluctuations, short-term hedging may be a good way to protect profits. This uncertainty ranges from suspicion of asset overbought to fear that political or economic instability may cause the value of certain foreign exchange pairs to plummet.

Traders often use hedging to prevent short-term fluctuations in economic news releases or market gaps on weekends. Traders should keep in mind that because hedging reduces trading risks, it also reduces potential profits.

Due to the low returns generated by hedging, this strategy is most suitable for traders who are engaged in the foreign exchange market full-time or who have a large enough account to generate a large amount of currency gains through a limited percentage of profits.

Exit hedge

When you exit direct or complex hedging and keep the initial position open, you only need to close the second position. However, when you close the two ends of the hedge, you will want to close both positions at the same time to avoid potential losses that may occur when a gap occurs.

It is important to track the hedging position so that you can close the right position at the right time to complete the execution of the strategy. Ignoring an open position in the process may derail your entire hedging strategy and may cause your trading account to suffer huge losses.

Always pay attention to risks when hedging

Although foreign exchange hedging is usually used to limit traders’ risks, poor execution of this strategy may have a disastrous effect on your trading account.

Due to the complexity of foreign exchange hedging, traders can never fully ensure that their hedging transactions can offset any possible losses. Even with a reasonable hedge, even with experienced traders, both parties may suffer losses. Factors such as commissions and swaps should also be carefully considered.

Traders should not engage in complex hedging strategies until they have a deep understanding of market fluctuations and how to arrange trading opportunities to take full advantage of price fluctuations. Time difference and complicated pairing decisions may lead to rapid loss in a short time.

Experienced traders can use their knowledge of market fluctuations and the factors affecting these price movements, as well as their familiarity with foreign exchange correlation matrices, to protect their profits and continue to generate income by using timely foreign exchange hedging.