Hedging is an investment strategy that has a purpose of protecting ourselves against a loss in another investment. A trade is made with the intent of making money. However, if it doesn’t work out, I am protecting myself by making another trade that can profit from my first trade not working out. It is like buying insurance on a car. If I experience a loss on my car, I have made an investment in the insurance to help offset the loss. The hedge offsets the loss but it also offsets gains because the hedge is a cost as well.
A hedge could be going long and going short on the same currency at the same time. Depending on the brokerage firm, you may not be able to even do this without an error message saying something like, “Hedging is prohibited.” But in this case, you are gaining and losing the same amount when movement occurs. When you consider the spread, the only way you would make money is if the spread narrows.
You could hedge by doing different lot sizes, where you make a bigger size trade on what you consider to be the most likely direction. Another way to hedge would be using different pairs that contain the same currency. You could go long the EURUSD and short the GBPUSD. In this case you are hedging the US dollar.
The best way to hedge for success would be to focus on the currency that recently shows the most strength and the most weakness against the currency you are hedging. In hedging the US dollar, for instance, what currency shows the most weakness recently against the dollar? The AUD seems to be the weakest recently. The NZD seems to show the most strength recently. In this scenario, you would look for the dollar to strengthen against the AUD and weaken against the NZD. Then you make the trade accordingly where you short the AUDUSD and long the NZDUSD. Depending on the pairs, it could be you are going long in both trades or short in both trades.
If the dollar strengthens, it should do so easily against the AUD but have a harder time against the NZD. So the gain will be greater than the loss. If the dollar weakens, it should do so easily against the NZD but not weaken as much against the AUD. Again, the gain would be better than the loss.
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