What Is Forex Hedging?
The easiest way to understand hedging is to think of it as insurance. When you hedge, you are insuring yourself against a negative event. This does not mean that once you hedge the negative event will not happen, but instead if it does happen the impact of the event is reduced. An example is like getting a car insurance.
With Forex hedging, you are essentially placing a bet in both directions of the market. You are placing a buy and a sell order on the currency pairs. This allows you to hedge your bet to reduce your risk in the Forex market and potentially profit from movement in either direction. This requires training and if done properly, it is a good skill to have as a Forex trader.
In Forex hedging, there are essentially a few types of hedging strategies
1) Buy and sell the same currency pair, same lot in the almost the same timing. After some time, one order will gain while the other will lose. When the winner run out of steam, take profit and wait for the losing trade to turn around. This strategy work well in a yo-yo kind of market trend.
Example: buy 1 lot EUR / USD at 1.3400 and sell 1 lot EUR / USD at 1.3397. If the price goes up to 1.3460 and we close the order to take 60 pips while the sell order has a drawdown of 63 pips. In such market condition, the rate will start to fall. If the rate fall to 1.3420 and you close the sell order with a loss of 23 pips. Overall we have gain 60 pips – 23 pips = 37 pips. Experience trader typically use technical analysis skills to decide their entry and exit points.
However such strategy is no longer allowed if you have a broker that adheres to National Futures Association (NFA) rules. If you sign up with a FOREX broker that is not in the NFA, you can still employ such hedging strategy in your account. For those that still wish to use hedging, there are a number of ways to do so.
2) Hedging with correlated pairs
Use currency pairs that have strong correlation. In other words, there are currencies that mirror each other as they move. The move can be directly or inversely proportional to each other. For example, if you look at charts of EUR / USD and USD / CHF pairs, you'll find very close similarity in the graph patterns. This means that traders can use this similarity in moves to try to reduce losses and built a hedging strategy that could combine these two currency pairs. Since EUR / USD and USD / CHF move inversely one can BUY both pairs. The result will be one order will gain profit, another will lose. Thus they will cancel each other. Hence, one can work out a profitable hedge strategy similar to item 1.
3) There are also other forms of hedging being employed, such as Hedging arbitrage – This technique involve getting 2 brokers. One charge interest and one do not. Buy from the broker that the currency pair that provides you rollover interest and sell from the broker that does not charge rollover interest. This way, you can gain the interest or SWAP that is credited to your account. Be careful not to get margin call, so managing the two accounts by transferring money from one account to another is crucial so that you have enough fund in both of them.
What are some of the pros and cons of Hedging?
Hedging can be very important when the market is highly volatile as it can be used to substantially reduce the risk levels. Hedge is also used to allow a trader to stay in a seemingly bad trade much longer, allowing for the market to correct back in the trader's desired direction. At the point that the hedging position is taken any existing loss is locked in, so if the trade never recovers, the trader will eventually need to take that loss. The good part is that you do not need to make that decision right away, thus give the market some room to move. If prices move back in your favor, the hedge position can be closed and the original trade now move in favor of your intended direction.
However, note that no strategy is fool proof and as such Forex hedging will not provide full coverage. Hedging will protect your investments to a certain degree, and when something bad occurs in the market, chances of you ending off better is higher than other traders who have opted not to hedge. When you decide to hedge, you must remember that it comes with a cost. You should make sure that the benefits you get from a hedge should be more than enough to make it worth your while. You should make sure the expense is justified. If it is not, then you should not hedge. The goal of hedging is mainly not to make large gains but instead it is used to protect your losses.
This article has briefly discussed the concept of Forex hedging and how it can be used. In short, Forex hedging is actually a protective strategy. It is typically not recommended for newbie. In manual trading, it is very important that you have a clear understanding of Forex hedging before you decide to use it as insurance. You need to ensure that you actually need it and the benefits you get from hedging are adequate enough to make it worth your while.