Hedging is simply coming up with a way to protect yourself against big loss. Think of a hedge as getting insurance on your trade. Hedging is a way to reduce the amount of loss you would incur if something unexpected happened.
Simple Forex Hedging
Some brokers allow you to place trades that are direct hedges. Direct hedging is when you are allowed to place a trade that buys a currency pair and then at the same time you can place a trade to sell the same pair. While the net profit is zero while you have both trades open, you can make more money without incurring additional risk if you time the market just right.
The way a simple forex hedge protects you is that it allows you to trade the opposite direction of your initial trade without having to close that initial trade. It can be argued that it makes more sense to close the initial trade for a loss and place a new trade in a better spot. This is part of trader discretion.
As a trader, you certainly could close your initial trade and enter the market at a better price. The advantage of using the hedge is that you can keep your trade on the market and make money with a second trade that makes a profit as the market moves against your first position. When you suspect the market is going to reverse and go back in your initial trades favor, you can set a stop on the hedging trade, or just close it.
There are many methods for complex hedging of forex trades. Many brokers do not allow traders to take directly hedged positions in the same account so other approaches are necessary.
Multiple Currency Pairs
A forex trader can make a hedge against a particular currency by using two different currency pairs. For example, you could go long EURUSD and short USDCHF. In this case, it wouldn’t be exact, but you would be hedging your USD exposure. The only issue with hedging this way is you are exposed to fluctuations in the Euro (EUR) and the Swiss(CHF).
This means if the Euro becomes a strong currency against all other currencies, there could be a fluctuation in EURUSD that is not counteracted in USDCHF. This is generally not a reliable way to hedge unless you are building a complicated hedge that takes many currency pairs into account.
A forex option is an agreement to conduct an exchange at a specified price in the future. For example, say you place a long trade on EURUSD at 1.30. To protect that position you place a forex strike option at 1.29.
What this means is if the EURUSD falls to 1.29 within the time specified for your option, you get paid out on that option. How much you get paid depends on market conditions when you buy the option and the size of the option. If the EURUSD does not reach that price in the specified time, you lose only the purchase price of the option. The farther away from the market price your option at the time of purchase, the bigger the payout will be if the price is hit within the specified time.
Reasons to Hedge
The main reason that you want to use hedging on your trades is to limit risk. Hedging can be a bigger part of your trading plan if done carefully. It should only be used by experienced traders that understand market swings and timing. Playing with hedging without adequate trading experience could be a disaster for your account.