Investors hedge their trades to reduce the risk in case the market starts moving against them. For example, a gold commodity trader will offset a long position by purchasing a put option to hedge against a decline in the price of gold. Currencies, however, are traded in pairs, and the traditional hedging strategies are not that effective. Still, there are ways in which currency traders can hedge their open positions to protect themselves against an unexpected market move.
Hedge your existing forex trade by opening a new position in a correlated pair. Some currency pairs move in the same or opposite direction. Pairs moving in the same direction 100 percent of the time have a +1 correlation. Those that move in opposite directions 100 percent of the time have a -1 correlation. Select a currency pair with +1 correlation and a currency pair with -1 correlation to hedge some of the risk. For example, go long with the EUR/USD (euro/U.S. dollar), which has a +1 correlation, and go long with the USD/CHF (U.S. dollar/Swiss franc), which has a -1 correlation. Each pair acts as a hedge for the other no matter which way the market moves.
Open a forex account with a brokerage firm that pays traders a positive rollover. Rollover is the interest a broker pays you for holding a particular currency trade overnight. For example, the GBP/JPY (British pound/Japanese yen) is a popular positive rollover currency. Buy the pair and hold the trade open indefinitely to collect daily interest on it. Protect the rollover trade by opening a forex account with a different broker that does not charge for holding a short position overnight. Open a short trade in the same currency. By being both long and short in the same currency, each will cancel the other out no matter how the market moves.
Open an account with a binary options brokerage firm and use binary options to hedge your forex trade. For example, if you are long with the EUR/USD pair, you want the euro to rise and the dollar to fall. To protect the trade, you could buy a binary option on the euro only, so that in case the EUR/USD price dropped the binary option would increase in value to help make up the loss.
- Popular forex currency pairs with +1 correlation are EUR/USD and GBP/USD; USD/CHF and USD/JPY; and AUD (Australian dollar)/USD and GBP/USD. Currency pairs that move inversely (-1) include EUR/USD and USD/CHF; GBP/USD and (USD/JPY); and AUD/USD and USD/JPY.
- Forex trading is very volatile and hedging strategies offer protection only against a portion of the loss. Invest only the money you can afford to lose.
Based in St. Petersburg, Fla., Karen Rogers covers the financial markets for several online publications. She received a bachelor's degree in business administration from the University of South Florida.