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. A foreign currency hedge is placed when a trader enter the foreign currency market with the specific intent of protecting exiting or anticipated physical market exposure from an adverse move in foreign currency rates.
Currency hedging strategies can be implemented in different ways and can vary based on the investor’s potential goal. You can have a systematic approach in place that mitigates risk when your exposure reaches a specific level, or you can use a discretionary approach when you perceive that the risks of holding directional currency risk outweighs the potential gains. Many traders will also use a currency option hedge to mitigate their forex exposure.
You perform direct forex hedging if your broker allows you to place a trade which buys a currency pair and simultaneously you are allowed to place a trade to sell the same pair. When the net profit comes to zero while you are having both trades open, you can earn more money without experiencing more risks if you only correctly time the market. The mechanism of how a simple forex hedging provides protection for you is that the hedging allows you to place trade the opposite direction of your first trade without the necessity of closing that first trade.
As a trader, you certainly could close your initial trade and enter the 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. 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.
A hedge inherently reduces your exposure. This reduces your losses if the market moves adversely. But if the market moves in your favor, you make less than you would have made without the hedge. Bear in mind that hedging: Is not a magic trick that guarantees you money no matter what the market does. Is a way of limiting the potential damage of an adverse price fluctuation, in the future. Sometimes simply closing out or reducing an open position is the best way to proceed. At other times, you may find a hedge or a partial hedge, to be the most convenient move.