Experienced traders engage in trading to take positions that cancel out the potential risk of future price fluctuations. This type of financial transaction is common, as most experienced and successful traders use hedging when trading on the forex market.
Traders use hedging to protect their positions against adverse moves in the markets. Forex traders can use one of two related strategies when hedging their positions in the markets.
Image showing how hedging works in forex
The “perfect hedge” strategy
Traders create a hedge that protects their current position from an unwanted move in the market, opening both long and short positions of the same currency pair. Traders refer to this strategy as the “perfect hedge.” It eliminates all potential risks related to the trade while the market is moving.
Even though this trade setup seems unusual due to the two opposing positions cancelling each other out, it is a standard setup in the forex market. Typically, traders use the perfect hedge when holding a short or long position as a short-term trade and incidentally take a contrary trade to profit from brief market instability.
Unfortunately, some forex brokers ban this type of hedging in the United States. Instead, what they do is net out of two positions by positioning the different trade as a close order; the result of a hedged trade is similar to a netted-out trade.
The “imperfect hedge” strategy
Traders protect their trades with the imperfect hedge strategy, which partially protects the current position from an opposing move in the currency pair using options in forex. This particular strategy uses forex options because it only eliminates some risk (while equally leaving some potential profit) concerning the trade.
To create an imperfect hedge, traders holding long currency pairs buy put option contracts to decrease their downside risk, while other traders keeping short currency pairs purchase call options to reduce their upside risk.
Live example of imperfect downside risk hedges
Traders need to know that put options contracts give buyers the right but not necessarily the obligation to sell a currency pair at a given price before the pre-determined date to the options seller for an upfront premium payment.
For example, a trader holding long positions on the EUR/USD at 1.265 will expect the pair to move higher. However, they may grow concerned about upcoming economic news that may make the pair move lower, eventually turning out bearish and blowing the account.
In such a scenario, they could hedge a position of their risk by buying put option contracts with a strike price below the current exchange rate, such as 1.2450, and an end date just after the economic news. Traders can continue holding the EUR/USD if the announcement is not stable. That way, they can make more profits the higher it goes, although it comes at a premium price for the put option contract.
Moreover, traders wouldn't have to worry about a possible bearish move if the news comes and goes and the EUR/USD starts moving lower. They know their risk is limited to the distance between the values of the currency pair, the time of buying the options contract, the strike price, and the premium paid for the contracts.
Live example of perfect upside risk hedges
A great example of the upside risk hedge is a scenario when a trader is holding short positions on the GBP/USD at 1.4325, expecting the currency pair to move lower. At the same time, the trader worries that the upcoming parliamentary vote could make the market direction turn bullish. In such a scenario, the trader hedges a portion of their risk by buying call option contracts with a strike price below the exchange rate, such as 1.4375, and an expiration date after the proposed vote.
If the votes are unstable and the GBP/USD stays at the same position, traders may continue holding onto the short positions of a GBP/USD trade, leading to more profits as it moves lower. The only risk remains the cost of the options contracts.
In a situation where the votes go up and the GBP/USD moves higher, traders wouldn't have to worry about any bullish wave because their risk has reduced to the distance between the value of the pair and the strike price of the option.
The bottom line
Hedging is a way of eliminating risk from the market, but it comes with a premium price tag. A hedge inherently reduces exposure to potential loss in adverse market conditions. Similarly, it reduces potential profit in favourable market conditions using the hedge.
Traders should not see hedging as a magic trick that guarantees them a profit regardless of the market conditions. Instead, it should be viewed as a way of limiting the potential loss of future price fluctuations.
Finally, traders should only use one of the two related hedge strategies that best fits their risk tolerance.