Hedging means 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.
In forex, 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.
- In foreign exchange (forex) trading, hedging is like getting insurance on your trade by reducing or covering the amount of loss that would be incurred.
- A simple forex hedge protects you because it allows you to trade in the opposite direction of your initial trade without having to close your initial trade.
- A forex trader can make a hedge against a particular currency by using two different currency pairs.
- Hedging on your trades helps limit risk, and it can be a big part of your trading plan if done carefully.
Simple Forex Hedging
Some 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.
The Protection of a Hedge
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 example 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.
Undoing a Hedge
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 account, so other approaches are necessary.
Multiple Currency Pairs
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 approach 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. Also, this method is generally not a reliable way to hedge unless you are building a complicated hedge that takes many currency pairs into account.
A forex option is an agreement to conduct an exchange at a specified price in the future. For example, say you buy a long trade position on EUR/USD at 1.30. To protect that position, you would place a forex strike option at 1.29.
This approach means that if the EUR/USD falls to 1.29 within the time specified for your option, you get paid out on that option. How much you get paid depends on market conditions when you buy the option and the size of the option. If the EUR/USD does not reach that price at the specified time, you lose only the purchase price of the option. The further from the market price, your option is at the time of purchase, the bigger the payout will be—if the price is hit within the specified timeframe.
Reasons to Hedge
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.
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