A:

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 a foreign currency pair, can protect themselves from downside risk; while the trader that is short a foreign currency pair, can protect against upside risk.

The primary methods of hedging currency trades for the retail forex trader is through:


Spot contracts are essentially the regular type of trade that is made by a retail forex trader. Because spot contracts have a very short-term delivery date (two days), they are not the most effective currency hedging vehicle. Regular spot contracts are usually the reason that a hedge is needed, rather than used as the hedge itself.

Foreign currency options, however are one of the most popular methods of currency hedging. As with options on other types of securities, the foreign currency option gives the purchaser the right, but not the obligation, to buy or sell the currency pair at a particular exchange rate at some time in the future. Regular options strategies can be employed, such as long straddles, long strangles and bull or bear spreads, to limit the loss potential of a given trade. (For more, see A Beginner's Guide To Hedging.)

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:

  1. 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.
  2. 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.
  3. 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.
  4. 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.

For more, see Practical And Affordable Hedging Strategies.

RELATED FAQS
  1. Is it possible to trade forex options?

    Yes. Options are available for trading in almost every type of investment that trades in a market. Most investors are familiar ... Read Answer >>
  2. What happens if you don't hedge your investments?

    Learn the purpose, advantages and disadvantages of hedging, and find out how to utilize hedging to enhance an overall investment ... Read Answer >>
  3. What is the purpose of a hedge fund?

    Find out what a hedge fund is, how it is set up and why it is different than other forms of investment partnerships like ... Read Answer >>
  4. What am I buying and selling in the forex market?

    The forex market is the largest market in the world. According to the Triennial Central Bank Survey conducted by the Bank ... Read Answer >>
  5. How do you make money trading money?

    How someone makes money in forex is a speculative risk: you are betting that the value of one currency will increase relative ... Read Answer >>
Related Articles
  1. Trading

    How To Avoid Exchange Rate Risk

    What are the best strategies to avoid exchange rate risk when trading?
  2. Trading

    The Forex Market: Who Trades Currency And Why

    The forex market has a lot of unique attributes that may come as a surprise for new traders.
  3. Trading

    Forex Trading: A Beginner's Guide

    Learn about the forex market and some beginner trading strategies to get started.
  4. Trading

    Hedging Basics: What Is a Hedge?

    This strategy is widely misunderstood, but it's not as complicated as you may think.
  5. Investing

    4 Reasons Currency Hedging is Important

    Learn how currency hedging can help reduce exchange rate risk for a portfolio of foreign stocks. Consider the cost of hedging and its potential benefits.
  6. Trading

    Top 5 Forex Risks Traders Should Consider

    With a long list of risks, losses associated with foreign exchange trading may be greater than initially expected. Here are the top 5 forex risks to avoid.
  7. Investing

    Getting Started In Foreign Exchange Futures

    Learn how these futures are used for hedging and speculating, and how they are different from traditional futures.
  8. Trading

    A Beginner's Guide to Hedging

    Learn how investors use strategies to reduce the impact of negative events on investments.
RELATED TERMS
  1. Forex Hedge

    A transaction implemented by a forex trader to protect an existing ...
  2. Forex Spot Rate

    The current exchange rate at which a currency pair can be bought ...
  3. Forex Option Trading

    A security that allows currency traders to realize gains without ...
  4. Foreign Exchange Market

    The market in which participants are able to buy, sell, exchange ...
  5. Forex Market

    The market in which participants are able to buy, sell, exchange ...
  6. Real Time Forex Trading

    A form of speculation in which a trader bets on the movement ...
Hot Definitions
  1. Book Value

    1. The value at which an asset is carried on a balance sheet. To calculate, take the cost of an asset minus the accumulated ...
  2. Dividend Yield

    A financial ratio that shows how much a company pays out in dividends each year relative to its share price.
  3. Fixed-Income Security

    An investment that provides a return in the form of fixed periodic payments and the eventual return of principal at maturity. ...
  4. Free Cash Flow - FCF

    A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents ...
  5. Leverage Ratio

    Any ratio used to calculate the financial leverage of a company to get an idea of the company's methods of financing or to ...
  6. Two And Twenty

    A type of compensation structure that hedge fund managers typically employ in which part of compensation is performance based. ...
Trading Center