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The foreign exchange (Forex) marketplace is one of the most popular financial markets for day traders. However, it is a highly volatile market, and so traders need strategies for managing risk.
One way you might manage the risk of Forex trading is by hedging trades. Below, we look at how hedging works and how you might use hedging in your strategy.
What Is Forex?
Forex (FX) is the global marketplace for buying and selling currencies. As it’s open 24/7, highly liquid, and subject to few rules and regulations, it’s appealing for day traders. However, the downside risks of FX trading are:
- Fluctuating exchange rates
- Market volatility
- Sensitivity to geopolitics
- Complex market to learn
The best trading strategy for Forex traders is one which allows them to trade freely while offsetting some degree of risk. That’s where hedging comes in.
What Is Hedging?
Hedging means you take two trading positions. You buy an asset solely to offset the risk of an adverse price shift in your core asset. Typically, this means taking a position in an asset going in the opposite direction from your primary asset.
Think of hedging as a balancing act. You’re trying to insure or protect yourself from a declining investment by “balancing out” possible losses.
What Is Forex Hedging?
Trading Forex involves buying and selling currency pairs. So, hedging Forex simply means you open a new trading position to protect your currency pair from losses.
How might you hedge Forex? There are two main options:
- Take different positions in the same currency pair; or
- Using options contracts to hedge your position.
We’ll look at these in more detail below.
To be clear, hedging Forex is not about making money. It’s about protecting yourself from market volatility. It’s only one trading strategy that you might use as a Forex day trader – and it’s not right for everyone.
Why Hedge Forex?
There are various reasons why you might hedge Forex.
- Currency exchange rates fluctuate frequently. So, currency hedging protects you, to some extent, from exchange rate volatility.
- Hedging can offset the risk of breaking news stories influencing the value of your pairs.
- Forex hedging can help day traders manage the risk of short, intra-day fluctuations.
What is an example of hedging? Consider a Forex hedge fund. Investors use these funds to collectively manage and mitigate risks.
But hedging is not just for wealthy investors. Traders at every level may opt for a hedging strategy.
Is Hedging Forex Legal?
The answer is: it depends on your broker and your marketplace.
Hedging itself is perfectly legal in most countries. And, in most countries, it’s legal to hedge Forex (even if some markets frown upon it). However, it’s often highly regulated and controlled.
In the US, for example, hedging Forex can be illegal. To legally hedge Forex, you must use brokers registered with the Commodities Futures Trading Commission (CFTC). They must also be National Futures Association (NFA) members.
Do Forex Brokers Allow Hedging?
To be clear, yes. If you want to use hedging, Forex brokers typically allow this. But you must follow their trading rules, and you must use regulated Forex brokers.
Always check the rules of your trading platform or prop firm before hedging Forex. Not all forms of currency hedging are permitted (especially in the US). If you don’t follow the rules, you risk financial (and legal) repercussions