The best forex hedging strategies

How do you hedge in forex? 

Hedging in forex is mainly used as a risk-management tool that can help mitigate short-term market movements. There are ways to hedge when you’re trading forex. However, this strategy can be broadly broken down in two ways: 

Perfect hedge 

A perfect hedge is where you hold a short and long position on the same currency pair. So, let’s say you hold a long position on USD/EUR. This means you believe the value of this currency pair will increase and, therefore, you’re willing to hold it for an extended period. 

However, let’s say there are some political events in America that make you wonder if there may be some volatility in the short or medium term. This volatility could essentially cause the value of USD/EUR to drop, so, instead of closing your long position, you open a short position. This means you’re simultaneously buying and selling the same currency pair. 

Holding both a long and short position in the same pair can reduce directional exposure, but it does not mean you can’t lose: costs (spreads/commissions/financing), execution differences, and timing can still result in losses.

However, that doesn’t make this a risk-free strategy because gains and losses may broadly offset each other, while costs and execution differences can still leave you with a loss. This is because the money you make from one position is cancelled out by the money you lose from the opposing position. Therefore, it’s not a risk-free strategy.

Forex traders who want to maintain a long position but protect themselves against short-term volatility will only use a perfect hedge for a certain period. Once the market appears to be moving into a favourable position, traders will close their short positions. 

Imperfect hedge 

An imperfect hedge in forex trading is where you use put options contracts to offset an existing position. This may not always be possible via your trading platform, but forex options are available at many banks. 

Forex options are derivatives based on underlying currency pairs. Forex options can take different forms (for example, ‘vanilla’ options and other structured option types offered by some providers). Availability and terminology vary by platform. These are options that give investors the right to buy (a call option) or sell (put option) a particular currency at a pre-set price at an execution date, as defined by the contract. 

An important caveat with options contracts is that they give investors the right to buy or sell, but there is no obligation to exercise that right. You have the “option” to fulfil the contract or not. So, by taking out a vanilla option, an investor can say how much of a particular currency pair they want to buy/sell, the price they want to pay and on the date they want to fulfil their order. 

This order is placed via your account. The premium is quoted by the market/provider and, if accepted, the option position is opened. Pricing and execution depend on the platform and market conditions. They hold a buy/sell position on a currency pair without actually owning the underlying asset.

Forex options example

So, let’s say you hold a long position on a currency pair. Depending on the product and account type, you are exposed to the exchange rate without owning the underlying currencies You want to protect against a certain amount of loss in the short-term by using forex options. You, therefore, take out a put option on the currency pair. If the value of falls, you’ll make money on your put option. If it increases, you’ll lose money on the put option but make a profit on your long position.

Forex options and imperfect hedging summary

We know this is complicated, so here’s a summary of imperfect hedging using forex options:

• Forex options are derivative contracts that give you the right to buy or sell a currency pair at a later date. You don’t have to fulfil this contract, but you’re purchasing the right to make your desired move in the future.
• A call option gives the right to buy and a put option gives the right to sell the underlying currency pair at the strike price. To buy means you’re taking a long position. To sell means you’re taking a short position.
• Options contracts are derivatives, which means you’re not purchasing the underlying asset which, in this case, are currency pairs. Instead, you’re paying for the right to make a move (buy or sell) a currency pair.
• You can have an options contract while holding another position.
• These hedges are known as imperfect because you won’t cancel out 100% of your losses on either side. Still, some traders use this strategy because it may limit part of the downside while retaining some upside if the market moves favourably.

Forex hedging strategies 

So, the two main forex hedging strategies are perfect and imperfect. To quickly recap, these two strategies are: 

Perfect hedging 

Also known as direct hedging, this strategy requires you to open long and short positions on the same currency pair. Any gains and losses may broadly offset each other, but net results can still be negative once costs, sizing and execution are taken into account. However, when used as a short-term strategy, it can be a way to protect long positions during times of volatility. 

*Perfect hedging isn’t always available, so check that it’s possible before opening a position. 

Imperfect hedging 

This strategy requires you to hold a position on a currency pair. You then take out an options contract in the opposite direction. This strategy won’t cancel out all of your profits, but the upside is that it leaves you with room to make a profit (although less than you’d make with a single position). 

Another approach sometimes discussed is by taking out positions on multiple currency pairs. The aim here is to hold two currency pairs that are closely linked. For example, you can hold a long position on EUR/USD and a short position on GBP/USD. 

With this forex hedging strategy, you’re taking two opposing positions. Even though these positions aren’t on the same currency pair, they both include USD. This approach aims to reduce exposure to a single driver, but correlations can change and it may not reliably offset USD moves. So, if something happens in the US and you feel it will hurt the value of the USD, you could have two positions on the USD using these two currency pairs.

The risks of forex hedging

Hedging doesn’t eliminate all risk and, in situations where it does, your net profit will be zero. This means you can’t use forex hedging to guarantee a profit. Even in situations where you try your best to eliminate your risk and end with a net profit of zero, you may have to pay trading fees, and in that case you’d actually lose money with a perfect hedge.

Forex hedging strategies can also be difficult to understand and implement, particularly if you’re a novice trader. This disadvantage becomes even more pronounced when you get into forex options. Finally, risk and rewards are closely correlated with each other. So, gains on one position may be offset by losses on another, but the offset is rarely exact once costs, sizing and execution are considered.

That can make hedging more relevant to short-term risk management than to long-term positioning, because reducing downside can also reduce upside. These are all important considerations.

Forex hedging strategies are useful and they can help you protect long positions during times of short-term volatility. However, forex hedging shouldn’t be seen as an easy way to make guaranteed profits and eliminate all of your risk in the long-term.