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. How can I invest in a foreign exchange market?

    The foreign exchange market, also called the currency market or forex (FX), is the world's largest financial market, accounting ... Read Answer >>
  4. How do hedge funds use short selling?

    Learn how hedge funds use short selling to profit from stocks that are falling in price. Explore different analytical techniques ... Read Answer >>
  5. If I use hedging as a risk strategy, do I have to keep my eye on my portfolio all ...

    Understand the concept of hedging and learn how this key element to portfolio management can help an investor protect profits ... Read Answer >>
  6. 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 >>
Related Articles
  1. Managing Wealth

    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

    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.
  5. Trading

    A Beginner's Guide To Hedging

    Learn how investors use strategies to reduce the impact of negative events on investments.
  6. Investing

    The Money Market Hedge: How It Works

    Investopedia explains how to hedge foreign exchange risk using the money market, the financial market in which highly liquid and short-term instruments like Treasury bills, bankers’ acceptances ...
  7. ETFs & Mutual Funds

    For Maximum Market Returns, Get Creative With Hedges

    Proper hedges help to contain your losses while still allowing profits to grow.
  8. Trading

    Hedging Basics: What Is A Hedge?

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

    A Beginner's Guide To Hedging

    Hedging is a practice every investor should know about.
  10. Managing Wealth

    Hedging for Beginners: A Guide

    People hedge as insurance against market volatility. Anyone can do it; here's a primer.
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. Foreign Exchange Market

    The market in which participants are able to buy, sell, exchange ...
  4. Forex Option & Currency Trading Options

    A security that allows currency traders to realize gains without ...
  5. Forex Option Trading

    A security that allows currency traders to realize gains without ...
  6. Forex Market

    The market in which participants are able to buy, sell, exchange ...
Hot Definitions
  1. AAA

    The highest possible rating assigned to the bonds of an issuer by credit rating agencies. An issuer that is rated AAA has ...
  2. GBP

    The abbreviation for the British pound sterling, the official currency of the United Kingdom, the British Overseas Territories ...
  3. Diversification

    A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique ...
  4. European Union - EU

    A group of European countries that participates in the world economy as one economic unit and operates under one official ...
  5. Sell-Off

    The rapid selling of securities, such as stocks, bonds and commodities. The increase in supply leads to a decline in the ...
  6. Brazil, Russia, India And China - BRIC

    An acronym for the economies of Brazil, Russia, India and China combined. It has been speculated that by 2050 these four ...
Trading Center