In the simplest terms, hedging can be described as a strategy for reducing risk and increasing winning probabilities. Hedging is a kind of insurance trick, just without an insurance fee. It simply refers to buying and selling two different assets simultaneously or within a short period. Hedging has become a common strategy in the Forex market. For example, hedging entails selecting two correlated currency pairs like the EUR/USD and the EUR/GBP and taking opposite directions on both pairs. This tactic or strategy is usually used to avoid risk when uncertainty is high. With brokers who allow direct hedging, you are allowed to buy a currency pair and, at the same time, place a trade to sell the currency pair. This is called direct hedging. Simply, you are allowed to trade the opposite direction of your original trade without having to close that trade first. Some would rather close the original trade for a loss, and open a new position, but hedging refers to making money even if the original trade evolves against your position because the profit increases simultaneously in the second trade. If the market should move back in favour of your first trade, you can simply close the hedging trade (second trade) or set a stop on it. The problem is that direct hedging is not supported by the majority of the brokers, and traders have to reach out for indirect methods and hedging strategies.
Indirect or Complex Hedging Strategies
In order to avoid direct hedging, traders can use two currency pairs. For example, the first trade referring to USD/GBP with a prediction that the USD will go up, while the second trade would include CHF/USD predicting that the USD would drop. In this case, a trader would secure and protect his position on the USD, which is positive, but at the same time, the trader is liable to fluctuations in the GBP and CHF. This type of hedging, where only one currency from a pair is protected, is not extremely reliable and profitable unless the trader has worked out a complex scheme including other currency pairs.
Forex Hedging and Risk Analysis
Hedging should always be preceded by a solid market analysis. This analysis can be divided into four parts:
a.) Risk analysis involves a risk assessment on the part of the trader who should evaluate if the risk can be covered by hedging or not, and if the risk is rather high or low.
b.) The risk tolerance threshold is a decision that should be made by the trader. The trader decides on his/her own to what extent he/she is willing to enter a risky trade. One thing is for sure, even if hedging is a means of protection, there is no Forex trade completely free of risk.
c.) Deciding on a Forex hedging strategy is the next step. One of the most popular includes the foreign currency options technique which grants the right to the trader to buy or sell a particular currency pair at a particular exchange rate at some point in the future.
d.) Close monitoring of the trade is recommended in order to observe if the strategy works and if any additional steps are needed to minimize the loss (like stop loss option, opening new positions, etc.)
Spot contracts have been one of the most common Forex strategies. However, spot contracts are not the most efficient methods for hedging, given that they are rather the cause hedging is needed. Spot contracts refer to regular contracts between retail Forex brokers and traders. The delivery dates are short, e.g. two days, and they are high risk propositions.
Hedging is Not Always Allowed
Many brokers do not allow hedging, especially not when trading with the bonus or promotion money. Using hedging in these situations can get you disqualified very easily. If interested in hedging and this kind of investment protection, make sure that your broker does not prohibit it. In most cases, the information is displayed on the broker’s website, so you can easily discover which brokers prohibit hedging. Moreover, hedging is illegal in the US Forex market and traders manoeuvre around the law to use hedging at least in some form as a technique (e.g. they can open accounts at two different brokers, opening one short and one long position).
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What Does It Take to Hedge?
Hedging can be very complicated and frustrating, especially if it has not been thought through. Many traders tend to fall into the vicious cycle of constantly adding and removing their positions in both directions. They struggle to find a profitable way out and do not want to give up on time. Hedging is, in every aspect, a technique reserved exclusively for experienced traders. Newcomers should stay away from hedging until they figure out the market and currency movements. Successful hedging also relies on accurate forecasts and thorough market studies and analyses. This means that traders really need to know the market in and out to make accurate predictions. Hedging requires a lot of patience, and many emotional traders cannot take the pressure, leading themselves to a dead end. It is hard to keep it cool when one has to watch over several positions. Moreover, sometimes the expiry dates can take weeks or months, which can be a real torture even for the calmest traders.
The True Risks of Hedging
a.) Many traders get stuck in their hedge trades for too long, waiting for a positive outcome. Another issue is that money withdrawals are not allowed during the hedging period.
b.) If it really gets ugly, you might have to succumb to the domino effect and open position after position (e.g. the first position requires you to open a second, if the second does not work, you open a third to cover for the second, and so on). Hedging gets easily out of control, and before you know it, you will be hedging all over the place.
c.) Profit loss due to hedging usually happens because traders lose their patience. Traders who have been stuck for too long in a hedging situation with multiple open positions usually come to the point where they close all positions at once which results in heavy profit losses.
This review shows that traders have to have a good plan to employ successful hedging strategies. Even if it provides security and protects positions, it can easily get out of control and expose traders to even greater risks and losses. Many examples prove that only experienced traders can successfully juggle between multiple open positions. Therefore, hedging is not for everyone, and many should rather take a pass on it. Skipping on hedging is far less risky than trying to protect your position when you are not really sure what you are doing.