Hedging

Hedging means reducing exposure to a risk you already have. For a business, it might mean locking in an exchange rate for a future payment. For a trader, it usually means taking a position that moves the opposite way to an existing one.

Forms of hedging in retail trading

• Direct hedge: holding a long and a short position in the same pair at the same time. Some platforms (such as MT4 and MT5 hedging accounts) allow this; others net positions so a sell simply reduces a buy.
• Correlated hedge: offsetting exposure with a related instrument, for example long EUR/USD and long USD/CHF, which have often moved in opposite directions. See correlation.
• Business hedge: a company with foreign revenue uses forwards or options to fix its conversion rate. This is the economic purpose of much FX trading.

Worked example

You are long one lot of GBP/USD from 1.2700 and the price falls to 1.2650, a 500-dollar unrealised loss. You open a one-lot short at 1.2650. From now on, further moves have no net effect: if price falls to 1.2600, the long loses another 500 and the short gains 500. But the original 500-dollar loss is still there, and you are paying spread on both trades and swap on both positions overnight.

Common misconception

A direct hedge of the same pair does not repair a losing trade. It freezes the result while adding costs, and closing the two legs later is a second decision just as hard as the first. In most cases, closing the position achieves the same economic result more cheaply.

See currency correlation.