When considering various forex trading techniques, hedging invariably stirs controversy.  Hedging is simply the practice of protecting or covering one trade position with another.  The simplest and most common method of forex hedging is to take a short position in a currency pair at the same time as a long one – that is, to buy and sell the same pair at the same time in the same amount.  When this is done, the gains of one position (the one which sees favorable price movement) are completely offset by the losses in the other.  From that point, the trader cannot incur losses, but she cannot enjoy gains either.

So, if the trader can neither gain nor lose, what’s the point?  Indeed, many traders ask that same question and there is considerable debate as to when hedging should be used and whether there’s any net benefit to it at all.  It should be mentioned that for a straight hedge as described above, the point is moot in the USA because the National Futures Association (NFA) which regulates trading markets has ruled against hedging.  It is no longer allowed for a trader to take opposing positions in the same market at the same time when trading with an NFA compliant broker.  For this reason many traders have shifted their activities to brokers located in other countries, such as the UK.

A straight hedge is used to allow a trader to stay in a seemingly bad trade much longer, allowing for the market to correct back in the trader’s desired direction.  At the point that the hedging position is taken any existing loss is locked in, so that if the trade never recovers, the trader will eventually need to take that loss.  The bright side is that she doesn’t need to make that decision right away, and can give the market plently of room to move.  If prices move in the ‘right’ direction, the hedge position can be closed and the original position played in the intended manner.

There are other forms of hedging employed, such as in interest rate arbitrage.  If a trader has accounts at two different brokers and there is a significant difference in the overnight interest rates charged (or paid) by those brokers, a hedge can be created across the two brokers for the purpose of taking advantage of the interest rate difference.  Also, many options trading strategies employ hedging of a sort, as puts and calls are played off against each other in an attempt to sculpt the outcome of a particular market’s movement.

All in all, forex hedging is a questionable tactic, but there are as many opinions about it as there are traders.  There are potential benefits, but there are also costs associated with such forex trading techniques.  Although straight hedging is now disallowed in the US, as a strategy the hedge is almost surely here to stay.