What is hedging as it relates to forex trading?

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, and
• Foreign currency options.

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.