In Forex trading, hedging can mean two things. Firstly, it can relate to the process of hedging or sterilizing a position by opening an equal and opposite trade to an open position. A trader might put on a hedge such as this if, for example, he or she wanted to retain a position overnight or over a weekend without experiencing any change in P&L, positive or negative.
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Imagine a trader is long one lot of GBPUSD, it’s nicely on side, and they decide to hold onto the position rather than close it, as they will be travelling and will be unable to monitor the position. To hedge that trade, they sell one lot of GBPUSD as a new opening position, not to close the existing trade.
They now have two positions open but their P&L is neutral from the time that they opened the short trade. The trader can close one or both of their positions in GBPUSD as and when they can trade again.
We can also hedge FX exposure of other positions. For example, if a trader has a portfolio of US equities in US dollars but their base or home currency is GBP, then they are long the US dollar and short the British pound by default and are exposed to underlying currency risk.
However, the investor could choose to hedge that currency risk with an FX trade, in case a purchase of GBPUSD with a notional value equivalent to the value of their underlying portfolio of US shares.
It’s also possible to hedge an FX position with a position in another FX pair or cross that is negatively correlated to the original position. Under a negative correlation, a change in the value of position A is offset by a change in the opposite direction in the value of position B. However, FX correlations are variable rather than static, so such hedges need to be well thought out and/or relatively short term.
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