How do you hedge in the forex market?

I was asked the following question the other day:

First, about hedging in forex market. How to do that? I read in other forum it is to buy and sell in one pair in spot market. I think that is wrong. Can you explain?

I’ve addressed this issue on a few occassions in a few places. Perhaps it’s worth sharing a quote from someone else on the subject. This is from GammaJammer on the Trade2Win forumÂ in addressing a similar question posted.

There is no such thing, at least not in the way you are most likely talking about. I am guessing you are referring to the practice, described by some retail traders as ‘hedging’ that consists of simultaneously being long and short the same currency pair. In the real world, this is know as being ‘flat’ i.e. having no position. But there is a ton of literature out there that will tell you otherwise. Question is whether or not you choose to believe it. Up to you.

And if you AREN’T in fact talking about this, my next guess as to what precisely YOU mean by hedging would be something like buying usd/chf to hedge a log eur/usd position (as they are fairly highly correlated). This is known as being long eur/chf, and isn’t really a hedge at all (apart from removing some of your USD exposure – not all mind you – watch it move around on payrolls day and you’ll see that for yourself).

An example of what is really meant by a hedge is to buy FTSE puts to hedge a long basket of stocks against a move to the downside. That kind of thing. The two examples of what retail traders get duped into thinking are ‘hedges’ are red herrings because in the case of the first example, all you have done is closed out your position (thus there’s no point in paying double the opportunity / margin costs to have two offsetting positions when you don’t make a bean regardless of where the market goes). And in the case of the second example all you have done is turned a position in one currency pair (eur/usd) to a position in another (eur/chf).

I couldn’t have said it any better myself. I look at forex “hedging” very much as a scam perpetrated on inexperienced forex traders by brokers of questionable ethics. I think most folks who have ever traded and/or dealt with Oanda would say they are among the best, most straightforward and ethicalÂ brokers in the market. That being the case, it speaks volumes that they do not permit “hedging” in the same account.

Continuing the earlier questioner’s inquiry:

okie dokie.. but the one i know is, if you buy in the spot market, then sell in the futures. is it true?

Effectively, that’s the same as going long/short in the spot. Spot and futures will converge at expriation and the gain/loss on the futures will be matched by the carry earned/paid on the spot (and of course the directional movement will even out). It’s basically a wash. Actually, given spreads and transaction costs, it more likely a losing proposition.

If you like this post or find it informative, I encourage you to sign-up for the newsletter.

Also subscribe to the blog feed and/or follow via Facebook or Twitter.

About the Author
John Forman, author of this blog, has traded for more than 20 years, is a professional market analyst, and authored The Essentials of Trading. He is an active participant in trading forums, consults for trading related businesses, as published literally dozens of trading articles, and has been quoted in a number of books and in the media.
** See John’s full bio.

Similar Posts:

Recent Posts

Key Site Content