How to Use Hedging in FOREX Trading

Traders look to profit from changes in a foreign currency pair’s (Forex) price. Traders apply technical analysis to determine optimal entry and exit points. If the analysis is correct, the investor will earn a profit. But the Forex market can also hand traders a loss should price move in the opposite direction. To prevent this, traders can employ different hedging strategies to protect their open positions and their investment capital.

Step 1

Get paid to keep your positions open. When you buy a currency pair, each currency has its own interest rate. The rollover is the difference between the interest rates. For example, say you are holding the EUR/USD (Euro dollar/U.S. dollar). The Euro has a 3 percent interest rate and the U.S. dollar a 1.25 percent interest rate. Subtract the Euro’s 3 percent from the U.S. dollar’s 1.25 percent, and the rollover rate you are paid is 1.75 percent.

Step 2

Protect your long rollover trade by opening a EUR/USD short position with a Forex broker that does not charge for holding short positions overnight. You are now long and short the EUR/USD while getting paid the rollover interest. Your EUR/USD trade is protected whether the price moves up or down.

Step 3

Protect against a breakout failure with binary options. Breakout failures occur when a currency pair’s price breaks out in the opposite direction of your trade. With binary options, you guard against a breakout failure by purchasing a short-term option in the opposite direction. For example, you decide to go long the EUR/USD and place a stop-loss at a major support price. You sell a EUR/USD binary option at your stop-loss price. Should the breakout fail, your binary option’s gain will make up the loss incurred by your long position loss and could even return a profit.

Step 4

Use currency correlation to hedge your Forex trades. The correlation rating tells you which currency pairs move together or opposite based on price moves. Currency pairs with a +1 rating move together nearly every time. Currency pairs with a -1 rating move opposite each other nearly every time. For example, the EUR/USD and the USD/CHF (U.S. dollar/Swiss franc) have a negative correlation to each other. You can protect your long EUR/USD position by shorting the USD/CHF currency pair. Should the EUR/USD price fall, the USD/CHF pair will gain in value.

Items you will need

  • Online Forex trading account

Tip

  • Forex currency correlation ratings change daily. Check the ratings before you enter a trade.

Warning

  • Forex trading can be very risky. Only trade with money you can afford to lose.

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