Looking for a Way to Protect Against Huge Losses? You Need to Learn About Hedging.
Sensible Forex traders are always looking for a way to limit their risks and improve their chances of winning. There are lots of different ways this can be done, but we’re going to focus here on one strategy that is also used by many large institutions. In the case of Forex trading, hedging isn’t a gardening term that refers to making interesting shapes out of trees and bushes. Hedging, in the Forex world, is a canny way in which you can insure against the worst outcome of a trade and reduce the impact of the adverse event. You’ll find it talked about on numerous occasions, and there are hedging Forex brokers who allow it and those that don’t. So what exactly is hedging, and is it a good or a bad thing to do?
What is hedging?
Hedging means buying and selling at the same time, or within a short period, two different instruments, which can be in different markets such as options and stocks, or in the same market such as the Forex market. It is very common to find traders using the hedging strategy, as well as institutions, some of which make it a mandatory part of their investment plan. If you have an interest in investment you will undoubtedly have heard of hedge funds. These are investment funds that “hedge” most of their trades. Hedging is a common term used in a number of different contexts, but we’ll be concentrating on its application in Forex trading.
When it comes to hedging, Forex brokers have different views. Some will welcome the practice, while others prohibit such a tactic. We should also point out that for US traders hedging is no longer allowed, due to new Forex regulations.
There are a number of different ways you can hedge a position, but the basic premise is that when you have a long position for a specific currency pair, you take out another position that will serve to protect the initial trade should the price of the pair go down, thereby limiting the downside risk of the initial position.
Alternatively, if you are in a short position you take another position on to protect the trade from upward risk. There are some common methods in which this can be done, and we’ll discuss these next.
Simple Forex Hedging
If you’re new to hedging this is probably the best place to start, because it is the simplest. Also known as direct hedging, it refers to having a long and short position on one currency pair. We’ll give you an example to better explain the principle:
- You’re long on EUR/USD at 1.12, and it starts to move against you. If you want to try your hand at hedging you should open a short position on EUR/USD at say, 1.10. Now you have to decide whether you think the rate of exchange is more likely to go up or down. If you can’t make a choice you can choose to leave both positions open until you get a prompt from a signal to either close, or set a stop to, both or either position. If you think the exchange rate is about to take a downturn, you have the option of closing the long position at a loss and allowing the short position to keep running at a profit. Whatever you decide to do, the losses from the initial long position are offset, all thanks to your sensible hedging.
Trading multiple currency pairs
Trading multiple currency pairs is another way to minimise your risk in Forex trading. Imagine the same scenario as above. In other words, you are in a long position on the EUR/USD and it looks like it’s going to move against you. You have the option to open another long position on USD/CHF. You’d do this because these two currency pairs have shown themselves in the past to have a high inverse correlation, which means they will often move in opposite directions to each other. You also have the choice of hedging an open position in order to look for currency pairs with high correlation. With a long position on EUR/USD that starts to move against you, there is the option to open a short position on GBP/USD.
You will, of course, need to be careful when using this particular hedging strategy, and ensure you have sufficient knowledge in relation to currency-pair correlation. This may be a hedging strategy that is more suitable for the experienced trader. There is a disadvantage with this particular hedging strategy, in that the interaction can become weak at any time, and also the fact that your losses may be minimised, but your profits will be reduced also.
These are just a couple of examples of ways in which you can take advantage of hedging in order to minimise your losses. Let’s discuss the steps you should take when developing your own hedging strategy…
Developing a hedging strategy in four easy steps
A hedging strategy in Forex trading is best developed in four parts:
- Analyse the risk – The first step a trader should take when considering adopting a hedging strategy is to identify the risk being taken in the current or proposed position. Then they will need to decide whether the risk is worth taking un-hedged.
- Determine risk levels – Every trader will have their own risk tolerance levels, and this will determine how much of the risk needs to be hedged. It is up to the individual trader to determine how much risk they are willing to take, and how much they are prepared to pay to reduce that risk.
- Decide on a Forex hedging strategy
- Put the hedging strategy into play and monitor it – Once the hedging strategy has been implemented it will need to be regularly monitored in order to ensure that the risk stays minimised.
Hedging is just one way in which a trader can reduce the risk involved in Forex trading. A big part of Forex trading is managing risk and money, so it’s always good to have as many tools as possible, and hedging is a great one to have in the arsenal. Remember, though, that not all retail Forex brokers allow hedging on their platforms, so be sure to do your research before you start to trade.