By: Charley Warady

Before getting into Forex hedging strategy, it would probably be best to explain hedging. It's pretty much the same as the phrase everyone has heard, “hedging your bets.” Hedging is defined as holding two or more positions at the same time, where the purpose is to offset the losses in the first position by the gains received from the other position. Yes, the profit turns out to smaller than a straight trade, but then again, so are the losses if you're wrong.

Hedging occursa in all markets and all forms of trading. Carrying a long position in one area, while carrying a short position in another area is commonplace among traders, and Forex hedging strategy works along the same lines.

Good idea

Like all forms of trading and strategy, the Forex hedging strategy is a good one if it works. For instance, if you buy the EUR/USD and the market is going down, you might want to hedge against this losing trade by selling the EUR/JPY. In essence then, what you're doing is taking both a long and short position on EUR and hoping the resulting trade will move in your favor. Large companies and financial institutions do this all the time.

This kind of trading can work to not only offset a loss, but also turn a loss into a profit. If nothing else, it may minimize your losses. When large companies and financial institutions do this, they are mainly doing it to protect profits they already have. When retail Forex traders do it, they are trying to offset, minimize, or reverse a losing trade. For obvious reasons, a Forex hedging strategy can be tricky.

Bad idea

Like all forms of trading with a risk, if it works you look like a genius; if it doesn't...well, you don't look like a genius. When you buy the EUR/USD and it goes against you, so you sell the EUR/JPY to protect yourself, more things than the obvious have happened.

It's true that you've both bought and sold the EUR, so the hedge has worked to your advantage as far as that is concerned. However, now you are left being short the USD and long the JPY. For those two currencies, you are exposed to the will of the market and that's the kind of exposure you may not want.

With any Forex hedging strategy, the Forex trader winds up, in a way, with more risk than he originally had with just a losing trade. If, when both sides of the hedge are executed and the USD goes down and the JPY goes up, then everything is good. Not only will the trader have limited his loss on the EUR/USD, but he may even turn a profit. But in the meantime, you'll have to keep a sharp eye on both markets, because it may wind up doubling your loss if the open ended currencies go against you.

Limiting risk

Every novice Forex trader is told not to be stubborn and stick to a plan. Usually a trader implementing a Forex hedging strategy is one that won't admit he's wrong about his original trade. Although it may work out for him, the risk is such that it's best to get out with a loss and move on to the next trade. Don't be stubborn. While you're trying to limit your loss, you might up extending your risk.