Forex Hedge

What is a 'Forex Hedge'

A forex hedge is a transaction implemented by a forex trader or investor to protect an existing or anticipated position from an unwanted move in exchange rates. By using a forex hedge properly, a trader who is long a foreign currency pair, or expecting to be in the future via a transaction can be protected from downside risk, while the trader who is short a foreign currency pair can protect against upside risk.

It is important to remember that a hedge is not a money making strategy. 

BREAKING DOWN 'Forex Hedge'

The primary methods of hedging currency trades for the retail forex trader is through spot contracts and foreign currency options. Spot contracts are the run-of-the-mill trades made by retail forex traders. Because spot contracts have a very short-term delivery date (two days), they are not the most effective currency hedging vehicle. In fact, regular spot contracts are often why a hedge is needed.

Foreign currency options are one of the most popular methods of currency hedging. As with options on other types of securities, foreign currency options give 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. (See also: Getting Started In Forex Options)

Forex Hedge Example

For example, if a U.S. company was scheduled to repatriate some profits earned in Europe it could hedge some, or part of the expected profits through an option. Because the scheduled transaction would be to sell euro and buy U.S. dollars, the company would buy a put option to sell euro. By buying the put option the company would be locking in an 'at-worst' rate for its upcoming transaction, which would be the strike price. And if the currency is above the strike price at expiry then the company would not exercise the option and do the transaction in the open market.

Not all retail forex brokers allow for hedging within their platforms. Be sure to research the broker you use before beginning to trade.