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PepperstoneWhat is Hedging in Forex?
Written by Steven Hatzakis
Edited by Jeff Anberg
Fact-checked by Joey Shadeck
Hedging is a strategy that allows investors to offload or counter certain kinds of risk. If you have exposure to a currency within a forex trade, trading in the opposite direction for that currency pair by the same amount will offset your position to zero, potentially removing risk for the duration of your hedge.
This guide will describe for beginners what it means to hedge in forex, explain how risk increases or decreases depending on the amount you hedge, and examine whether hedging makes sense for your 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.
What is hedging in forex?
Hedging in forex (directly or indirectly) occurs when you hold two positions for the same amount of currency in two different directions. This can be a way to reduce or remove exposure to exchange rate volatility as any profit made on the original trade is offset by a loss on the hedging trade (and vice versa).
For example, if you buy 10,000 EUR/USD to open a long position and simultaneously sell 10,000 EUR/USD to open a short position, you now have a hedged trade.
Hedging’s Alternative:
By default, most brokers prevent hedging through a process called netting. This involves offsetting the initial trade by the amount of the new position instead of creating two trades. In our example, the second trade would simply close out the first instead of keeping both open.
Traders will often adjust the size of their hedged trade based on market sentiment or their specific trading strategy.
How does hedging work?
When you completely hedge an investment you remove the potential for both profits and losses by holding opposing trades of the same size for the same underlying asset. Regardless of which way the market price moves, a loss on one side is offset by an equal profit on the other (as long as both sides of the trade remain intact and any trading fees are ignored).
It’s important to note that the timing of when the hedge trade is placed relative to the original trade matters immensely. If you place both trades at the same time, there will be no way to recoup your trading costs for as long as both remain open. A trader must eventually exit one side of the two trades first, with either a profit or loss on that position, and hope they will subsequently realize a profit on the remaining side.
Check out my guide to the best hedging forex brokers to find trusted brokers that offer hedging as a trading option.
Alternatively, especially when direct hedging is not legal or allowed by your broker, a trader can hedge indirectly by opening a position on a different instrument for the same asset class. An often-used strategy is to buy or sell forex options to hedge a spot position of forex. For example, a trader can indirectly hedge a long-term position in a currency pair by purchasing a forex put option on that same pair. In the event the currency drops, the trader will hopefully profit from the put option to counteract at least some of the loss taken in the long-term position.
Advantages of hedging in forex trading
While there are many advantages for businesses and institutions when engaging in forex hedging to protect from exchange rate fluctuations during commercial transactions, for retail forex traders the need to hedge is usually far more short-term (or may not be necessary at all).
Hedging is advantageous if you have a long-term position in one direction and are optimistic that it will eventually pay off, but temporarily open an opposite position to profit from expected short-term movement in that opposite direction.
Hypothetical example:
Let’s say you expect the EUR/USD price will go up by next month and are long 30,000 EUR/USD at 1.1055 with a target price of 1.1200. However, in the short term, you believe the price might first pull back to 1.0920. As a hedge, you open a short position selling 30,000 with a plan to close the position at a target of 1.0920.
Disadvantages of hedging in forex trading
The biggest disadvantage of hedging in forex trading is that it can be difficult to overcome trading costs, including spreads, commissions, and overnight carry charges. Opening the multiple and distinct trades necessary for hedging potentially incurs all of these costs.
It is usually easier to simply close your existing trade if you wish to open a trade in the opposite direction. Otherwise, you will need to monitor both sides and the degree of risk or reward on each trade while factoring in varying trade sizes.
For example, if you are buying 50,000 units of currency long but only partially hedge by selling 20,000 units short, you have a net exposure of 30,000 long but with an added layer of complexity due to the hedge. This is why most brokers offset the first trade through netting by default and would close the initial position by 20,000 rather than create two opposite positions.
Be wary of using leverage to hedge
Hedging in forex can introduce unnecessary complexity and may be best avoided unless you have a concrete reason to hedge exchange-rate risk or are hedging as part of a well-thought-out trading strategy.
Due to the difficulties in using hedging to trade successfully, as experienced by the many people who lost money incurring trading costs from hedge trades, U.S. regulators banned hedging for forex retail trades entirely in 2009. Even if you reside in a region that allows hedging, managing the added complexity of tracking multiple positions in opposite directions can be difficult and prone to additional losses or unexpected costs.
Depending on the broker's requirements and the amount of leverage being used, some brokers will require that you deposit additional margin for the hedging trade. However, other brokers may not require additional margin when a trade is perfectly hedged or only require additional margin for unhedged positions.
Real-life example:
I once devised a trading strategy that relied upon hedging because I was holding multiple positions across various currency pairs and needed to offset certain positions with opposing trades for my strategy to work. This is known as a “carry trade” strategy that relies on higher interest yield currencies.
Basic example of hedging in forex
The most basic way to think of hedging in forex is simply holding two positions for the same amount of currency in two different directions.
For instance, buying 10,000 EUR/USD (a long position) and selling 10,000 EUR/USD (a short position) will create a hedged position. The second trade is the hedge. This is an example of a perfect, or market-neutral, hedge; any profit on one trade is offset by a loss in the opposing trade until you decide to close one side.
It is common to have instead a different-sized trade in an opposing direction, where only the portion that offsets each other is considered a hedge. For example, buying 30,000 EUR/USD and selling 10,000 EUR/USD as a hedge results in a net-long position of 20,000 while both trades are still open. Only the 10,000 overlap is considered to be hedged.
Is forex hedging profitable?
No, not with a position that is fully hedged. When fully hedged, the opposing trade will offset any profits or losses on the initial trade. The determining factor as to whether the trade will end up profitable is what occurs after the hedge is closed.
Many scenarios are possible depending on the market conditions, with the best case being that you close the hedge at the correct time to profit in its direction, and then wait until the market reverses to profit on the initial trade. In the worst case, you close the hedge at a loss and do the same for the initial trade. Keep in mind you may experience an overall loss even with otherwise neutral hedges due to the trading costs associated with opening more than one trade.
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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.