Forex hedging is a strategy of offsetting risks of significant losses while holding an asset in an adverse market condition.
For beginners, hedging refers to an advanced risk management process that involves buying and selling financial assets to reduce the risks of existing positions. Traders execute hedge trade, particularly when they don’t want to realize the floating losses. Instead, they open countertrade positions intending to minimize the overall loss probabilities.
The concept of hedging was implemented during the mid-19th century when dealers and farmers agreed on a future price for buying and selling grains in Chicago. For example, a bread factory comes under a future contract with farmers to purchase grains at a specific price rate.
So, the factory ensures they’ll not overpay for grains even if the price hikes in the future. On the other hand, farmers agreed to the contract to confirm the sale of the grains at a fair price. Here, both parties considered hedging as insurance that will not guarantee their profits but offers a safeguard against anomalous losses.
In forex trading, hedging is a popular technique for offsetting the risks resulting from unexpected market movements. As it is easy to identify an opposite currency pair to hedge, traders find themselves more flexible in applying the hedging strategy in forex trading.
In this guide, we’ve explained what exactly hedge trading means in forex. Also, we’ve discussed a few forex hedging strategies which are simple but carry a higher probability of success.
What is Hedge Trading in Forex?
Hedge trading in forex involves opening one or more counter trades to reduce the floating losses of the existing position.
As the largest financial market in the world, forex is highly liquid and may turn extremely volatile. Traders aim to capitalize on such volatilities by entering trades within the current market momentum. However, in trading, profit probability is proportionate to potential risks.
So, it is quite usual to experience adverse results while trading FX pairs due to unexpected price movements. If you want to continue holding a losing position but are wary of significant losses at the same time, then hedging is the best strategy to manage the risk.
Hedge trading in forex is a great way to diversify the portfolio. Since profit and loss are uncertain in trading, professional traders find it safe to distribute the risks by holding multiple positions of different assets with negative correlations. So that even if a trade turns up in an adverse position, another trade may move just the opposite.
How Does FX Hedging Work?
Since the forex market comprises plenty of financial assets and intends to move within trend cycles, it gives more hedging options than other industries.
FX hedging involves holding multiple positions of negatively correlated currency pairs, expecting the trades will move on in different directions and plot an ideal balance between profit and loss. Since forex currency pairs are directly correlated, it is easier to identify opposite trades and hedge opportunities.
The hedge trading strategy may work for both day and intraday traders in forex. However, hedging while frequent trading may involve high costs and commissions. Also, it may lead to overtrading and significant losses instead of reducing the risks. For this reason, hedging in forex day trading is only recommended for well-experienced traders.
The most consistent way to hedge in forex is position trading. Position traders wait for the price to hit their predetermined buy/sell zone before deciding on an entry. They trade less and focus on perfect trends, key price levels, and solid signals for anticipating A+ trading opportunities. Since they weigh more on quality than quantity, they get more time to analyze their trading positions and spot precise instruments to hedge the current exposure.
Depending on your trading situation, styles, and requirements, you may choose one or multiple hedging strategies in forex.
So, which FX hedging strategy is the best?
Let’s find out!
Forex Hedging Strategies
1. Direct Forex Hedging Strategy
It is a basic forex hedging strategy involving opening long and short positions of the same currency pair.
For example, you enter long on GBP/USD at 1.2500 with a stop-loss at 1.2300. When the price falls to 1.2450, you realize that the price has a strong potential for a sharp bearish move that may also hit your stop-loss. Eventually, you enter short at 1.2450 so that even if the price continues the bearish rally, your current short position will offset the losses resulting from the long entry.
However, a hedge trade may not always perform as expected since the market sentiment may reverse at any moment. So, always consider placing a stop-loss for the hedging position. If the market favors the first entry, simply let the second entry hit the SL. Alternatively, you can close the hedging trade manually when you spot a solid price-action signal that supports your decision.
Risk management strategy plays a significant role in such adverse hedging conditions. Suppose you maintain a 1:2 risk to reward ratio. Hence, if your hedging entry makes a 50 pips loss, then target at least 100 pips profit from the first entry so that you can still be in a 50 pips net profit at the end.
2. Correlation Forex Hedging Strategy
According to the correlation forex hedging strategy, a trader will open a position with a different currency pair that negatively correlates to the current position.
For example, you go long with GBP/USD but find that the pair starts moving opposite to your trade entry, increasing the floating loss. In such a case, if you wish to hedge the USD exposure, you may enter a short position of EURUSD. Because both euro and pound often show the same sentiment against the US dollar.
At any point, if GBP/USD declines, EUR/USD can fall too. Eventually, EUR/USD short turns out as an opposite entry and offsets the loss resulting from the GBP/USD long.
When the strategy goes in your favor, you have multiple options to exit your entries. You may exit all the positions in breakeven, ensuring a complete loss recovery. Alternatively, you can wait until the profit of one entry exceeds the loss of another one.
Although, trading multiple currency pairs involve significant risks. Sometimes, the pairs may start moving partway, causing further losses. It mostly happens during sensitive news events. So, it is essential to keep an eye on the economic calendar and avoid hedging during important announcements.
Furthermore, you must be familiar with technical factors like trends and price-level analysis. It’ll help you filter potential opportunities and determine the timing of entries and exits.
3. Simple Forex Hedging Strategy for Options Trading
A forex option is an agreement with the broker that gives you the right (not the obligation) to buy/sell a currency at a fixed price, also known as the strike price, and with a specific expiry date. So, if you find the hedge is working opposite to your expectation, you may simply wait until the option expires and only pay the premium for opening the position.
For example, you enter long on GBP/JPY at 160.00. Later, due to a change in the market momentum, you expect the British pound will sharply fall against the Japanese yen. So you decide to hedge the risk exposure by placing a daily put option (right to sell) on GBP/JPY at a strike price of 159.00. If the price moves below 159.00, the put option will turn profitable and offset the loss generated from the GBP/JPY long. If the pound starts rising against the yen, let the put option expire and only pay the premium.
The main purpose of forex hedging is to offset the risk exposure resulting from the unexpected turnaround in market conditions. However, it may not necessarily suit everyone, especially when you are comfortable with only one trade at a time. Since hedging involves multiple entries, it may become difficult to monitor all the entries and make precise decisions simultaneously.
Forex hedging is not only a risk management strategy; it is also a skill that requires a lot of practice in live markets. Beginners must start hedging with demo accounts and use the strategy in real trading only after properly mastering the skill.
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