Hedging is simply coming up with a way to protect yourself against a big loss. When you buy car insurance, you're protecting, or hedging, against the chance of having an expensive accident. This article will help you understand the meaning of hedging with some forex hedging strategies and examples
What is Hedging?
In forex trading, think of a hedge as getting insurance on your trade. Hedging is a way to reduce or cover the amount of loss you would incur if something unexpected happened.
Forex hedging is the act of strategically opening additional positions to protect against adverse movements in the foreign exchange market. Most traders and investors will seek to find ways to limit the potential risk attached to the exposure, and hedging is just one strategy that they can use.
Understanding Forex Hedging
A trader might opt to hedge forex as a method of protecting themselves against exchange rate fluctuations. While there is no sure-fire way to remove risk entirely, the benefit of using a hedging strategy is that it can help mitigate the loss or limit it to a known amount.
Currency hedging is slightly different to hedging other markets, as the forex market itself is inherently volatile. While some forex traders might decide against hedging their forex positions – believing that volatility is just part and parcel of trading FX – it boils down to how much currency risk you are willing to accept.
If you think that a forex currency pair is about to decline in value, but that the trend will eventually reverse, then hedging can help reduce short-term losses while protecting your longer-term profits.
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Forex Hedging Strategies
There is a vast range of risk management strategies that forex traders can implement to take control of their potential loss, and hedging is among the most popular. Common strategies include simple forex hedging, or more complex systems involving multiple currencies and financial derivatives, such as options.
Simple Forex Hedging Technique
The best forex brokers allow you to place trades that are direct hedges. A direct hedge is when you are allowed to place a trade that buys one currency pair, such as USD/GBP. At the same time, you can also place a trade to sell the same pair.
While the net profit of your two trades is zero while you have both trades open, you can make more money without incurring additional risk if you time the market just right.
A simple forex hedge protects you because it allows you to trade the opposite direction of your initial trade without having to close your initial trade. One can argue that it makes more sense to close the initial trade at a loss, and then place a new trade in a better spot. This is one of the types of decisions you'll make as a trader.
You could certainly close your initial trade, and then re-enter the market at a better price later. The advantage of using the hedge is that you can keep your first trade on the market and make money with a second trade that makes a profit as the market moves against your first position.
If you suspect that the market is going to reverse and go back in your initial trade's favor, you can always place a stop loss on the hedging trade, or just close it.
There are many methods for hedging forex trades, and they can get fairly complex. Many brokers do not allow traders to take directly hedged positions in the same forex account so other approaches are necessary.
Some providers do not offer the opportunity for direct hedges, and would simply net off the two positions. With AM Broker, the MetaTrader 5 platform enables you to trade in the opposite direction from your initial trade, keeping both positions on the market.
Multiple currencies hedging technique
A forex trader can make a hedge against a particular currency by using two different currency pairs. For example, you could buy a long position in EUR/USD and a short position in USD/CHF. In this case, it wouldn't be exact, but you would be hedging your USD exposure. The only issue with hedging this way is you are exposed to fluctuations in the Euro (EUR) and the Swiss (CHF).
This means if the Euro becomes a strong currency against all other currencies, there could be a fluctuation in EUR/USD that is not counteracted by your USD/CHF trade. This is generally not a reliable way to hedge unless you are building a complicated hedge that takes many currency pairs into account.
It is important to remember that hedging more than one currency pair does come with its own risks. In the above example, although you would have hedged your exposure to the dollar, you would have also opened yourself up to a short exposure on the pound, and a long exposure to the euro.
If your hedging strategy works then your risk is reduced and you might even make a profit. With a direct hedge, you would have a net balance of zero, but with a multiple currency strategy, there is the possibility that one position might generate more profit than the other position makes in loss.
In sum, Hedging is
The main reason that you want to use hedging on your trades is to limit risk. Hedging can be a bigger part of your trading plan if done carefully. It should only be used by experienced traders that understand market swings and timing. Playing with hedging without adequate trading experience could reduce your account balance to zero in no time at all.
Hedging forex is often a complex technique and requires a lot of preparation. Here are some key points for you to bear in mind before you start hedging:
- Forex hedging is the practice of strategically opening new positions in the forex market, as a way to reduce exposure to currency risk
- Some forex traders do not hedge, as they believe volatility is part of the experience of trading forex
- There are two popular hedging strategies: simple forex hedging and multiple currencies hedging
- Before you start to hedge forex, it is important to understand what is forex and how does it work, choose your currency pair and consider how much capital you have available
- It is a good idea to test your hedging strategy before you start to trade forex on live markets
Start Hedging Forex
You can test out your hedging strategies in a risk-free environment by opening a demo trading account with AM Broker. If you are ready to implement your forex hedging strategy on live markets, you can open an account with AM Broker – it only takes a few steps, so you can be ready to trade on live markets as quickly as possible. Use code WELCOME30 to get a FREE $30 welcome bonus.
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