Forex hedging is hedging in the Forex market. Hedging involves a trader reducing his/her risk in trading. This does not eliminate the risk or the damage caused by an unexpected event in the market that causes the position of the trader to adversely affect his/her funds, but proper hedging can reduce the negative effect on those funds.
A trader who is long in a currency pair can use hedging to protect himself/herself from downside risk, while a trader who is short in a currency pair can use hedging to protect himself/herself from upside risk.
The easiest way for a trader to implement Forex hedging is to make another transaction involving another currency. This currency should have a negative relationship with the currency involved in the first transaction.
For example, if you are going long on U.S. dollars and an event in the world leads to either the U.S. dollar or the Japanese yen increasing, with the other currency falling, you can protect yourself by going long on Japanese yen. This way, no matter which currency increases, you will gain.
For those experienced traders who know how to use hedging in their trades, hedging can really keep losses down to a minimum. However, there are some risks to hedging that you need to know about before you start using it.
Realise that hedging does come at a price - you have to pay for the hedges, regardless of whether you needed them or not. You have to make sure that the hedges are worth the money you will spend on them, especially if the expected negative result does not happen. If you can't justify the money you will spend on the hedge, then you should not hedge your primary investment.
Additionally, Forex hedging in itself will not make you money; it is there to help protect your funds from adverse and unexpected events that would cause your primary investments to lose money. You need to be sure that the hedge will protect you as well as you think it will. Those who are inexperienced or who are not fully aware of how hedging works may think that they are protected to a large degree by a hedge he/she executes, then find out after an adverse event that the hedge didn't protect them as much as expected or at all. This can result in devastating losses from the primary investment AND the cost of the hedge as well.
Implementing proper Forex hedging can be an effective tool for the knowledgeable trader. Proper hedging can eliminate much of the risk and financial losses that traders can experience when adverse and unexpected world events cause the currency values to fluctuate in ways that are not expected. By learning how and when to hedge, you can increase your chances of being successful of trading on the Forex market.