The FOREX Hedging Theory

Hedging is used in virtually all markets. As the largest global market, Forex is certainly no exception to this rule. The essential theory behind hedging is to eliminate risk by offsetting an existing position in the real world or the Forex market itself.

Hedging in Forex
Hedging is the practice of taking an offsetting position on an existing position in order to eliminate risk. Therefore, a hedge in Forex serves to protect against a currency rising or falling in value. International financial institutions, businesses and individual traders all make use of hedging in Forex.

Trade Risk
When a business imports or exports goods, there is an exchange rate risk. For example, a U.S. company planning to import TVs from Japan will lose money if the yen strengthens against the dollar. Therefore, that company will buy yen in the Forex market to hedge their exchange rate risk. If the yen strengthens, the profits made in Forex will offset the real world losses.

Impact of Leverage
Because of the leverage afforded by the Forex market, a hedge can be established using a relatively small amount of margin. For example, someone with a 50:1 leverage ratio only needs $2,000 margin to trade a $100,000 contract. Typically, if a Forex position moves against a trader, they are often required to deposit more margin to hold the position. However, if a position moves against a hedger, this indicates that their real world position is profitable, so they can elect to exit the Forex market or establish a new hedge if deemed necessary.

Trading Strategy
Some Forex traders utilize hedging as part of a trading strategy. In this strategy, the trader buys and sells the same currency pair simultaneously. It is usually employed in a range-bound market where a currency pair is moving back and forth in a narrow price range. The hedging trader then sets limit orders at the limits of the range to take profits and anticipates a price reversal back towards the other end of the range.