How to use hedging strategies in forex trading?
General Tips

How to use hedging strategies in forex trading?

Hedging refers to the equal proportion of opposite positions for a given portfolio. An example is when you go long on EUR/USD with $1000 and go short on EUR/USD with $500, giving you 0 net exposure to the currency pair.

The idea behind hedging is that it reduces your risk by reducing your exposure to an economic event.

There are several ways traders hedge in forex trading:

  • A covered interest arbitrage strategy
  • Natural hedging
  • Futures contracts and options contracts

What is Hedging?

Hedging can be defined as “the activity of protecting an investment from risk by taking an offsetting position in a related security.”

In other words, hedging is when you take action to reduce the risk associated with an investment.

Hedging can be done in several ways, but the most common way to hedge in forex trading is to use futures and options contracts. Let’s take a closer look at each of these methods now.

Hedging with Futures Contracts

A futures contract is a legally binding agreement between two parties to exchange an asset at a set price and date in the future.

Traders often use futures contracts to hedge their positions in the underlying asset. For example, let’s say that you are long EUR/USD with a position size of $1000.

You could buy a futures contract for EUR/USD to hedge your position. It would lock in the price of your original trade and protect you from any downside movement in the EUR/USD currency pair.

Hedging with Options Contracts

An options contract is a contract that gives the buyer the right, but not the obligation, to purchase or sell an asset at a set price and date in the future.

Options contracts can be used to hedge positions in the underlying asset or to create speculative positions.

For example, let’s say that you are long EUR/USD with a position size of $1000. You could buy a put option for EUR/USD to hedge your position. It would give you the right to sell your original trade at a set price in the future, protecting you from any downside movement in the currency pair.

Innate Hedging

Natural hedging is a type of hedging built into the design of some financial instruments. Natural hedging can be used to reduce risk in a portfolio or to create a directional bet. An example of natural hedging can be found in currency futures contracts.

When you buy a currency futures contract, you are purchasing exposure to the underlying currency pair. Therefore, it is a directional position and can be thought of as a hedging strategy (because you are reducing your risk).

Future Contracts

A futures contract is an agreement to buy or sell an asset at a set price and date in the future. Traders often use future contracts to hedge their positions in the underlying product.

Buying futures contracts can also allow you to gain exposure to overvalued assets without the need for additional capital.

Let’s say that you are long EUR/USD with a position size of $1000. You could buy 100 futures contracts for EUR/USD to hedge your position. It would lock in the price of your original trade and protect you from any downside movement in the currency pair until expiration.

Options Contracts

An options contract is a contract that gives the buyer the right, but not the obligation, to purchase or sell an asset at a set price and date in the future.

Options contracts can be used to hedge positions in the underlying product or to create speculative positions.

For example, let’s say that you are long EUR/USD with a position size of $1000. You could buy one call option for EUR/USD to hedge your position. It would give you the right to buy 100 shares of your original trade at a set price (the strike price) in the future, protecting you from any upside movement in the currency pair until expiration.

Note: buying an options contract is not using hedging strategies because you are still taking a directional position in the underlying product.

Innate Hedging

Innate hedging is a type of hedging built into the design of some financial instruments.

Innate hedging can be used to reduce risk in a portfolio or to create a directional bet. An example of Innate hedging can be found in currency futures contracts.

When you buy a currency futures contract, you are purchasing exposure to the underlying currency pair. Therefore, this is a directional position and can be thought of as a hedging strategy (because you are reducing your risk).