Hedging is an investment strategy for the purpose of protecting other financial investments from potentially large losses.
In the same way, in Foreign exchange trading, traders who are long on a particular currency pair can protect their positions by being short on a different Forex pair.
Let’s say that a trader believes the Australian dollar is very weak at the moment and that it will depreciate sharply. So he decides to short the AUD against the US dollar. Let’s say that an important economic report will be released from the US tomorrow. This puts the trader at a significant risk, like a gamble. If the report is positive he will profit and if the report is negative for the US then he will lose on his position.
Now, what can this trader do?
For instance, he can hedge his position by shorting the dollar on a different Forex pair. For example, let’s say he believes that the New Zealand dollar is much firmer than the AUD at the moment. So to hedge his initial short AUDUSD position the trader can go long on NZDUSD. Any weakness in the dollar will be offset by his long NZDUSD while still benefiting from the weakness of AUD.
Another good way to hedge in the Forex market is through currency options. Since an option gives the investor the right but not the obligation to buy or sell a currency, he can exercise this option accordingly.
Lastly, let’s talk about a common misconception of hedging among retail traders.
In retail Forex trading, hedging is usually considered as holding two contrary positions on the same currency pair. Hence the trader neither wins nor loses as the two positions cancel each other out. Doing this doesn’t really make sense because there is no way to profit from such a trading practice until you take the risk and close one of the positions. The US National Futures Association even banned this kind of hedging because it is only damaging to the retail trader as he pays the costs of spreads and swaps while having zero chances of winning.