Basically, hedging involves the buying (or selling) of currency pair(s) in order to protect the hedger against unwanted currency fluctuations. Traditionally, hedging was used to protect the profits of multinational companies from unfavourable currency fluctuations.Hedging is a great way for these companies to protect their profits, but unfortunately many inexperienced Forex traders have incorrectly applied the same principles to their trading activities.
Here’s how a Forex trader may try to hedge his position:
Imagine that I buy the EUR/USD currency pair, and the market immediately moves against my position (i.e. prices went down). At this moment, I would be facing an unrealized loss. In order to ‘protect’ myself against further losses, I might sell the EUR/JPY currency pair in the hopes that any gain in the latter pair will partially offset the losses of the former pair.
Essentially, I’ll be holding on to two simultaneous ‘long’ and ‘short’ positions for the Euro currency
. Hedgers hope that the results of both positions will partially cancel each other out.
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