In a simple explanation, hedging is a way to get yourself protected against a big loss. You can even make an analogy of a hedge as having insurance for your trade. With forex hedging, you employ a method of decreasing the amount of loss that you are likely to experience if something bad comes up.
You may be allowed to place trades which are direct hedges by several fx brokers. You perform direct forex hedging if your broker allows you to place a trade which buys a currency pair and simultaneously you are allowed to place a trade to sell the same pair. When the net profit comes to zero while you are having both trades open, you can earn more money without experiencing more risks if you only correctly time the market.
The mechanism of how a simple forex hedging provides protection for you is that the hedging allows you to place trade the opposite direction of your first trade without the necessity of closing that first trade. Some people argue that it is more sensible if you just close the first trade for a loss since a new trade can always be placed in a much better spot. This is in fact the trader’s discretion part. Of course you could always close your first trade, as a trader, and get into the market at a better price. However, the benefit of using the hedge is that your trade can be kept on the market and that you can earn money with a second trade which is profitable while the market is moving against your initial position. When you feel that the market will reverse and move back in your first trade, a stop can be set on the hedging trade, or simply close it.
Having been through with the simple forex hedging, the discussion is now carried on to the complex hedging. Complex hedging of forex trades can be done in many ways. Nevertheless, there are many brokers who would not let traders take direct hedge positions in one account, so it is necessary to apply other approaches.
A forex hedging against a specific currency can be done by a forex trader by employing two dissimilar currency pairs. The statement can be exemplified as follows. Assume that you were able to go long EUR/USD and short USD/CHF. In this illustration, it would not probably be precise, but you would hedge the exposure of your USD. The only problem with this method of hedging is that you are open to fluctuations in the Euro (EUR) and the Swiss (CHF). This situation means that if the Euro gets to be the strongest again the others, there can be a fluctuation in EUR/USD which is not counteracted in USD/CHF. This hedging method is usually not reliable if you are not building a complicated hedge which takes into account many currency pairs.
An agreement to perform an exchange at a certain price in the future is called a forex option. For instance, you trade long on EUR/USD at 1.30, and you place a forex strike option at 1.29 to protect your trade. It means that if the EUR/USD drops to 1.29 within the duration specified for your option, you are paid out on that option. When you purchase the option and how big the options is determine the amount of your payment.