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. In simplest terms, a trader who is long on a particular currency pair can hedge to protect against downside risk exposure. On the other hand, a trader who is short on a particular currency pair can hedge to protect against upside risk exposure.
The way a simple forex hedge protects you is that it allows you to trade the opposite direction of your initial trade without having to close that initial trade. It can be argued that it makes more sense to close the initial trade for a loss and place a new trade in a better spot. As a trader, you certainly could close your initial trade and enter the forex market at a better price. The advantage of using the hedge is that you can keep your trade on the market and make money with a second trade that makes profit as the market moves against your first position.
Some brokers allow you to place trades that are direct hedges. Direct hedging is when you are allowed to place a trade that buys a currency pair and then at the same time you can place a trade to sell the same pair. While the net profit is zero while you have both trades open, you can make more money without incurring additional risk if you time the market just right. When you suspect the market is going to reverse and go back in your initial trades favor, you can set a stop on the hedging trade, or just close it.
The forex 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. Forex hedging may not be as simple as you think because there’s a particular strategy you have to follow in order to make the best out of the system. The main objective of using this strategy is to minimize loss and profit is only secondary but with proper technical analysis and experience, the main aim of using this strategy may be to make profits.
When implementing a forex hedging strategy, remember that trading and hedging foreign currencies is often an imperfect science. The main reason that you want to use hedging on your trades is to limit risk. Hedging can be a bigger part of your trading plan if done carefully. It should only be used by experienced traders that understand market swings and timing. Playing with hedging without adequate trading experience could be a disaster for your account.