What is hedging as it relates to forex trading?

Hedging is a strategy to protect one's position from an adverse move in a currency pair. Forex traders can be referring to one of two related strategies when they engage in hedging.

A forex trader can create a “hedge” to fully protect an existing position from an undesirable move in the currency pair by holding both a short and a long position simultaneously on the same currency pair. This version of a hedging strategy is referred to as a “perfect hedge” because it eliminates all of the risk (and therefore all of the potential profit) associated with the trade while the hedge is active.

Although this trade setup may sound bizarre because the two opposing positions simply offset each other, it is more common than you might think. Oftentimes this kind of “hedge” arises when a trader is holding a long, or short, position as a long-term trade and incidentally opens a contrary short-term trade to take advantage of a brief market imbalance.

Interestingly, forex dealers in the United States do not allow this type of hedging. Instead, they are required to net out the two positions – by treating the contradictory trade as a “close” order. However, the result of a “netted out” trade and a hedged trade is the same.

A forex trader can create a “hedge” to partially protect an existing position from an undesirable move in the currency pair using Forex options. Using forex options to protect a long, or short, position is referred to as an “imperfect hedge” because the strategy only eliminates some of the risk (and therefore only some of the potential profit) associated with the trade.

To create an imperfect hedge, a trader who is long a currency pair, can buy put option contracts to reduce her downside risk, while a trader who is short a currency pair, can buy call options contracts to reduce her upside risk.

Put options contracts give the buyer the right, but not the obligation, to sell a currency pair at a specified price (strike price) on, or before, a pre-determined date (expiration date) to the options seller in exchange for the payment of an upfront premium.

For instance, imagine a forex trader is long the EUR/USD at 1.2575, anticipating the pair is going to move higher, but is also concerned the currency pair may move lower if the upcoming economic announcement turns out to be bearish. She could hedge a portion of her risk by buying a put option contract with a strike price somewhere below the current exchange rate, like 1.2550, and an expiration date sometime after the economic announcement.

If the announcement comes and goes, and the EUR/USD doesn’t move lower, the trader is able to hold onto her long EUR/USD trade, making greater and greater profits the higher it goes, but it did cost her the premium she paid for the put option contract.

However, if the announcement comes and goes, and the EUR/USD starts moving lower, the trader doesn’t have to worry as much about the bearish move because she knows she has limited her risk to the distance between the value of the pair when she bought the options contract and the strike price of the option, or 25 pips in this instance (1.2575 – 1.2550 = 0.0025), plus the premium she paid for the options contract. Even if the EUR/USD dropped all the way to 1.2450, she can’t lose any more than 25 pips, plus the premium, because she can sell her long EUR/USD position to the put option seller for the strike price of 1.2550, regardless of what the market price for the pair is at the time.

Call options contracts give the buyer the right, but not the obligation, to buy a currency pair at a specified price (strike price) on, or before, a pre-determined date (expiration date) from the options seller in exchange for the payment of an upfront premium.

For instance, imagine a forex trader is short the GBP/USD at 1.4225, anticipating the pair is going to move lower, but is also concerned the currency pair may move higher if the upcoming Parliamentary vote turns out to be bullish. She could hedge a portion of her risk by buying a call option contract with a strike price somewhere above the current exchange rate, like 1.4275, and an expiration date sometime after the scheduled vote.

If the vote comes and goes, and the GBP/USD doesn’t move higher, the trader is able to hold onto her short GBP/USD trade, making greater and greater profits the lower it goes, and all it cost her was the premium she paid for the call option contract.

However, if the vote comes and goes, and the GBP/USD starts moving higher, the trader doesn’t have to worry about the bullish move because she knows she has limited her risk to the distance between the value of the pair when she bought the options contract and the strike price of the option, or 50 pips in this instance (1.4275 – 1.4225 = 0.0050), plus the premium she paid for the options contract. Even if the GBP/USD climbed all the way to 1.4375, she can’t lose any more than 50 pips, plus the premium, because she can buy the pair to cover her short GBP/USD position from the call option seller at the strike price of 1.4275, regardless of what the market price for the pair is at the time.