What is Forex Hedging

What is forex Hedging

Hedging is generally understood as a strategy which protects investors from occurrence of events which can cause certain losses.

The idea behind currency hedging is to buy a currency and sell another in the hope that the losses on one trade will be offset by the profits made on another trade. This strategy works most efficiently when the currencies are negatively correlated.

Thus, you should buy a second security aside from the one you already own in order to hedge
it once it moves in an unexpected direction. This strategy, unlike most trading strategies already
discussed, is not used to make a profit; it rather aims to reduce the risk and uncertainty.

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It is considered a certain type of strategy whose sole purpose is to mitigate the risk and enhance
the winning possibilities.

As an example we can take some currency pairs and try to create a hedge. Let’s say that at a
specific time frame the US dollar is strong, and some currency pairs including USD show different
values. Like, GBP/USD is down by 0.60%, JPY/USD is down by 0.75% and EUR/USD is down by
0.30% . As a directional trade we had better take the EUR/USD pair which is down the least and
therefore shows that if the market direction changes, it will go higher more than the other pairs.

After buying the EUR/USD pair we need to choose a currency pair that can serve as a hedge.
Again we should look at the currency values and choose the one which shows the most comparative
weakness. In our example it was JPY, and EUR/JPY would be a good choice. Thus, we can hedge
our trade buying EUR/USD and selling EUR/JPY.

What is more important to note in currency hedging is that risk reduction always means profit
reduction, herein, hedging strategy does not guarantee huge profits, rather it can hedge your investment and help you escape losses or at least reduce its extent. However, if developed properly,
currency hedging strategy can result in profits for both trades.

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