The term hedging often appears in forex transactions. Forex hedging is a trading method that places opposite orders on the same currency pair to limit risk to the lowest level. So what is forex hedging?
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What is forex hedging?
Forex hedging is a trading method where a trader trades the same currency pair with the same volume but two opposite orders. When the price goes against the expected direction, the trader closes the position and waits for the remaining position to break even or up to profit.
Example: Trader buying 0.5 lots EURUSD and selling 0.5 lots EURUSD means covering 0.5 lots.
What are forex hedging strategies?
There are many methods to manage trading risk and hedging is one of the most popular.
There are two forex hedging strategies, including simple hedging and multi-currency hedging.
Simple Forex Hedging
Some brokers allow traders to open positions as direct cover. Direct hedging opens a long position on a currency pair and simultaneously opens a short position on the same currency pair.
The profit at the opening of two trades will be zero. Investors can make more money without taking the additional risk if they choose the right time to enter the market.
The advantage of using hedging is that the trader can hold the first position and make money with the second position by making a profit while the market moves against the first position.
If the trader suspects that the market has reversed and returned to the original position, the trader should place a stop-loss order on the hedging trade or close the order.
There are many forex hedging strategies out there and they can get quite complicated. Many brokers do not allow traders to use hedging in the same account, so other approaches are needed.
Multi-currency hedging strategy.
Traders can be hedging for a specific currency using two different currency pairs. For example, a trader buys a long position EUR/USD and a short position USD/CHF. If the euro strengthens against all other currencies, there may be volatility in EUR/USD which is not counterproductive from the trader’s USD/CHF trade.
Hedging multiple currency pairs also carries risks. If the hedging strategy works, the investor’s risk is reduced, making a profit. With a natural hedging strategy, net balance = 0. However, with a multi-currency Forex hedging strategy, one position will likely generate more profits than losses from another position.
A Few Notes Before Using Forex Hedging Strategy
- Not all brokers allow traders to use hedging in trading.
- Using hedging, the trader will incur two spreads due to opening two orders at once.
- There is no guarantee that currency pairs will be 100% inversely correlated. There will be a small chance that both orders are inversely correlated with the forecast.
- Traders should consider using hedging on low-volatility currency pairs to minimize risk.
Forex hedging is a hedging method, but the trader will also have to pay a fee in executing two positions at once. This transaction fee will be incurred when the trader trades more. The Forex hedging strategy will help investors protect their capital account when the market moves against the trend. However, if the market goes in the right direction, the trader also loses a significant profit.
To make a profit, traders should consider using a reasonable Forex hedging strategy against large market fluctuations.
What are the mistakes when using forex hedging?
These mistakes often appear to newbies or inexperienced traders.
Unable to identify trend range and coverage in a chaotic way
The price fell after placing a buy order, but they did not dare to reduce their losses. Fearing that the price would continue to fall, they placed a sell hedging order. Usually, the price will continue to fall and they will close the sell order for a small profit. However, there are some cases when the price drops until they run out of the buy order. For these cases, the coverage is just in time to drive up the price.
Such hedging causes traders to lose direction and continuously places buy/sell orders. This will cost traders a lot of trading fees.
Uif an unjustified hedging strategy.
Traders using hedging strategies do not follow any basis. They constantly place buy/sell orders. When an order has a small profit, close the order. At that time, all the results of closed positions were profits. However, non-closed trades are making more significant losses.
When losses are closed, small profits do not compensate.
Conclusion
The article introduced what is forex hedging? Hedging helps traders protect capital when the market moves in an unfavorable direction. However, when it goes according to the forecast, the trader loses a profit. So use a solid forex hedging strategy against big swings.
