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PepperstoneCommon Forex Hedging Strategies
Written by Steven Hatzakis
Edited by Jeff Anberg
Fact-checked by Joey Shadeck
Though hedging in forex is complex, it can have a place in a well-rounded portfolio or trading strategy. The ability to hedge directly will depend on your broker and any applicable local regulations. That said, it’s important to understand common hedging strategies – even if you won’t be employing them in your own portfolio.
Although this guide is not intended as trading advice, I’ll explore various approaches to forex hedging strategies for educational purposes and provide useful tips if you decide to incorporate one into your portfolio or forex trading strategy.
CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74% and 89% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
Common forex hedging strategies
Perfect hedge
A perfect hedge means that both sides of a position, the original trade and hedging trade, are the same size and asset. They perfectly cancel each other out as long as they both remain intact - profits on one side will offset losses from the other.
For example, you might open a short position by selling 20,000 USD/JPY because you expect the US dollar to weaken against the Japanese Yen. Later, if you expect market volatility due to an upcoming event and wish to temporarily protect against risk without closing the initial trade, opening a long position for the same amount by buying 20,000 USD/JPY would represent a perfect hedge against your original short position.
Once the hedged trade is in place, any new profits or losses from either side will be entirely offset by the other.
It’s important to be aware that holding perfect hedges overnight will still incur carry costs, which are always a net negative (any positive credit from a trade on one side of the position is always less than the negative debit from the other side).
What is hedging?
New to the world of hedging? Learn the basics by checking out my intro guide to hedging forex trades (it's a great resource for beginner forex traders).
Imperfect hedge
An imperfect hedge is similar to a perfect hedge, with one important difference; in an imperfect hedge, the size of the hedged positions do not cancel out. If you hedge for an amount that's either larger or smaller than the original trade amount, you've opened up an imperfectly hedged position.
For example, if you are long 20,000 units of a currency pair and then open a hedged trade by going short 30,000 units of the same currency pair, then it is an imperfect hedge. Only 20,000 units are perfectly hedged. The extra 10,000 unit portion of the hedge trade is fully exposed - your position is net short by 10,000 units.
In the opposite scenario, if you are long 30,000 units and then hedge with a short position by selling 20,000 units, it would be an imperfect hedge that is net long by 10,000 units.
Carry trade hedging
Carry trade hedging is a strategy that attempts to optimize interest rate earnings while offsetting currency exposure. It can be a complex trading problem to tackle because of the number of variables and calculations involved while also keeping track of which currency pairs either charge or pay you interest when you buy or sell.
Let’s consider the following hypothetical scenario: the Central Bank of Turkey has interest rates near 45% and the Turkish lira (TRY) is depreciating. Buying the TRY against a low-interest currency like the EUR would pay a hefty yield of 30%, but the cost to hedge TRY by opening a short position would incur significantly more interest at 50%. The closer you make this carry trade hedge to a perfect hedge (market neutral), the more expensive it will be and less profitable in terms of earning interest. The less you hedge this position, the more interest you earn – but you risk the increased exposure to the underlying currency. If the value of TRY rapidly depreciates, it would offset any gains you made from the carried interest.
It’s crucial to understand whether the rollover on the currency you’re trading is a credit or debit, depending on whether you go long or short. You must also take into account your exposure across currencies and how to best offset it while keeping the total interest earned positive (i.e., a net credit).
Correlation hedge
When examining the relationship between currencies, currency pair exchange rates tend to exhibit degrees of correlation over time (although this is not always predictable or reliable for future projections).
One strategy employed is called statistical arbitrage, which attempts to profit from the expectation that a divergence of correlated values will converge back to the baseline. In the case of a correlation hedge, a trader will attempt to buy one and sell the other in hopes of making a profit (in even more complex strategies, more than two pairs are used).
Some cross-currency pairs are even correlated directly with their underlying major pair constituents since they are calculated deterministically. For example, to calculate the price of the GBP/JPY pair you would multiply the price of USD/JPY with the price of the GBP/USD.
To open a correlation hedge for a long GBP/JPY position, you could buy the USD/JPY and short the GBP/USD. The hedge trades are effectively long USD strength against GBP and JPY while the initial trade is long GBP strength against JPY (both GBP and JPY would benefit from USD weakness). In other words, the overall position would help hedge some risk but still expose you to potential JPY strength (i.e., leaving it as an imperfect hedge).
The following graph of the relationship matrix for the three positions will help visualize all the possible results of the various positions:
| Trade Position | If GBP Strengthens | If USD Strengthens | If JPY Strengthens |
|---|---|---|---|
| Long GBP/JPY | Positive Impact | No Direct Impact | Negative Impact |
| Long USD/JPY | No Direct Impact | Positive Impact | Negative Impact |
| Short GBP/USD | Negative Impact | Positive Impact | No Direct Impact |
Direct hedge
A direct hedge is when you use the same underlying asset to open a hedge trade in the opposite direction to an initial trade so that you are simultaneously long and short. The motivation behind this strategy is to profit on the temporary short position while maintaining a long position if you expect only a short-term downtrend in the asset.
An applicable scenario for this strategy is if you have an open position in the EUR/USD for 20,000 units and already have a profit of 200 pips after buying at 1.0750. The current market price is 1.0950 and you expect the market to reach 1.11 by the end of the week. However, some bad economic news just hit and you now believe that in the short term, the price could dip to 1.08 before returning higher by the end of the week.
In order to open a direct hedge, you would keep your long position open but then sell an equal amount of 20,000 EUR/USD as a hedge trade. If your expectations turn out to be correct, you would close the short position at 1.08 to profit from the dip and then eventually close the long position at the end of the week when the market reverses and hits 1.11.
Not permitted everywhere:
Some brokers do not permit direct hedging (particularly U.S. brokers who are unable to offer it by law). One alternative that may be provided is a “Close and Reverse” order that lets you quickly change directions by exiting your current position and opening a new one in the opposite direction without hedging.
General tips when hedging
Example forex hedging trading plan
In the following example of direct hedging with forex trading, we will be placing two hypothetical trades in the same underlying currency pair, one trade long (buying) and one trade short (selling). They will be for the same amount, but not at the same time.
Hypothetical Entry Plan:
- Original trade: Buy 10,000 EUR/USD at an ask price of 1.1055 at 9:55 a.m., creating an unrealized loss of $4 since the current hypothetical bid price is 1.1051.
- Hedging trade: Sell 10,000 EUR/USD at a bid price of 1.1051 at 9:57 p.m., locking in the $4 loss, plus the spread paid on the hedge trade which cannot be recouped while it is open.
Hypothetical Exit Plan:
- Exit the hedge trade at 1.1001 for a 50 pip profit ($50), while still holding an unrealized loss of $54 on the original trade, in hopes that the market will eventually recover and go higher.
- Best case scenario: The market returns higher above the entry of 1.1055 and the original trade no longer has the unrealized $54 loss and turns a profit instead.
- Worst case scenario: The market plunges even lower resulting in a deeper unrealized loss. You will either need to exit the trade manually, have a stop-loss order triggered, the broker may initiate a margin call if your portfolio becomes overleveraged, or you will simply be tied up in the position longer waiting for a recovery that may not materialize anytime soon.
FAQs
When should you hedge when trading forex?
Whether you should hedge when trading forex depends on a variety of factors, including whether your broker offers hedging or if hedging is permitted in your country of residence.
I would not suggest hedging for the sake of hedging, as it can add unnecessary complexity to your trading and introduce additional trading costs that can be difficult to overcome while in a hedged position.
An example of where hedging might be required is with an algo trading system that runs concurrent strategies and can manage multiple positions that each have different time horizons or target durations (i.e. an intraday position alongside a longer-term trade). However, unless you have a specific need or trading strategy that requires it, hedging is not necessary when trading forex.
How do I test my hedging strategy before implementing it?
Using a demo account can be a great place to optimize your strategy, adjust its parameters, and observe how well it succeeds in backtesting before forward testing with real funds.
While a demo account is an excellent way to learn how a trading platform works, results from trading with paper money (fake currency) should not be taken as an indication of how well a strategy will operate using real money. When the stakes become real, strategies tend to shift or suffer from the complexities of real-world market conditions.
A careful way to transition to a live account is to continue testing your hedging strategy on a small scale by using micro contracts and a small deposit to help verify its performance before scaling to a more substantial amount and risking more money. If you decide to open a live trading account, make sure it's with one of the best forex brokers.
What are the best tools to test a hedging strategy?
The best hedging brokers offer various tools such as trading and margin calculators - directly integrated into their trading platforms - that can help you with your planning when creating a trading strategy for hedging. For example, Saxo was the winner of our Platforms & Tools Award in 2024 and offers an assortment of features for hedging.
In addition, if you are running an algorithmic trading strategy that uses hedging, you can backtest it on historical data using platforms such as MetaTrader (MT4 and MT5), cTrader, and TradingView.
MT4 or MT5?
Can't decide whether you should go with MT4 or MT5? Check out my MT4 vs MT5 guide for my insights into the differences between these two powerful trading platforms.
What is the best forex hedging strategy?
There is no single best strategy for everyone, period. Whether your strategy involves hedging or not, its value to you will depend on current market conditions, your individual needs and goals as an investor, your experience as a trader, your available resources and tools, and a multitude of other factors.
For example, I’ve seen traders utilize a straddle strategy with success going into volatile events such as economic news releases, but such a strategy is a bit of a gamble as even with volatility you don’t know which way the market will move first and by what degree before reversing.
What is a straddle?
A straddle is when a trader goes long and short at the current market price, expecting a large move in either direction. They then attempt to close one trade at a profit while exiting the other trade either at a smaller loss or holding longer for a potential profit (at the risk of a greater loss). Timing is key and the strategy can be highly risky.
The success of any strategy will always depend on the behavior of the market at the time you deploy it, the experience and skill with which you implement it, and every small variable distinct to each trade like execution quality. It is never guaranteed whether a strategy will be profitable.
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About the Editorial Team
Steven Hatzakis is the Global Director of Research for ForexBrokers.com. Steven previously served as an Editor for Finance Magnates, where he authored over 1,000 published articles about the online finance industry. A forex industry expert and an active fintech and crypto researcher, Steven advises blockchain companies at the board level and holds a Series III license in the U.S. as a Commodity Trading Advisor (CTA).
Jeff Anberg is a Staff Editor at ForexBrokers.com. Along with years of experience in media distribution at a global newsroom, Jeff has a versatile knowledge base encompassing the technology and financial markets. He is a long-time active investor and engages in research on emerging markets like cryptocurrency. Jeff holds a Bachelor’s Degree in English Literature with a minor in Philosophy from San Francisco State University.
Joey Shadeck is the Content Strategist and Research Analyst for ForexBrokers.com. He holds dual degrees in Finance and Marketing from Oakland University, and has been an active trader and investor for close to ten years. An industry veteran, Joey obtains and verifies data, conducts research, and analyzes and validates our content.