What is Hedging in Forex?
Hedging in forex is a common feature for many trading accounts provided by brokers. Hedging also refers to a tactic used to offset risks.
Hedging is yet another delightful piece of Forex trading jargon which can have various meanings in different circumstances. Besides many other important matters, we shall explore the varying definitions to ensure you understand clearly what is hedging in forex and why it’s essential you know it.
A common talking point for new traders is hedging in forex. But, the term is somewhat ambiguous. One of the most notable features of FX and CFD trading is being able to go long and short on a wide range of currency pairs, commodities and other global markets. Most retail forex trading accounts allow hedging. Hedging is a practice that you could be following without even noticing.
In this article, we will explore what a hedging forex account is, how that trading account is different from other types, the concept of hedging risk and then more specifically we’ll look at various forex hedging strategies.
Hedging Forex Trading Accounts
If you’re opening a trading account with a forex broker based pretty much anywhere on earth, except for the United States, then you can expect your trading account will be hedging-enabled.
If you have a hedging trading account, it means you can simultaneously have a long and short position open for the same trading pair. The alternative to a hedging account is a Netting account, and it does not allow you to be concurrently long and short on the instrument.
Netting works by netting your orders against positions if you have any. To put it simply, if you are long 1-Lot EUR/USD and then go short 1-Lot EUR/USD you will have no positions open in your account. The second short trade will have effectively closed the initial long position. Many traders find this style of trading incredibly prohibitive.
Because there is virtually zero demand for a netting forex account, brokers tend not to advertise them or even negate offering them altogether.
The most straightforward way to explain hedging risk is to take a specific action to counteract the risk of another. To use an example unrelated to finance, hedging could be described as buying two t-shirts online; one Medium and one Large size. The risk is that you don’t know which size will fit best, and the hedge is purchasing the two sizes most likely to fit you.
In the context of finance and investing, risk hedging is a tactic used to limit the downside of your investments. Whenever you own an asset, or you are in a trade, you’re exposed to the risk of loss.
A finance orientated example of hedging risk would be a hedge fund which typically invests in stocks and treasury bonds. As those assets are underperforming, the fund manager may decide to gain exposure to gold for hedging risk. Stocks and cash are not correlated to gold. Typically gold performs best when stocks aren’t, the gains from the exposure to gold can be used to offset the losses from other assets in the portfolio.
As you can see from the example above, the motivation for investing in gold wasn’t speculative; it was, in fact, strategic. The overall purpose was to protect the primary investments, which in this case was stocks and bonds.
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Hedging Forex Positions
Hedging in Forex requires you to take into account the spread at every level. Banking, insurance, shipping, aviation, commerce, manufacturing and many other industries rely on hedging foreign currency exposure risks. Consider a European airline that sells tickets to British tourists in GBP needs EUR to pay salaries and USD to purchase fuel. As you can imagine, if the Pound slips, it can inflict significant issues to their operations. That’s why many multinational companies work with brokers to hedge their risks.
Obviously, as an independent forex trader, your trading style will be very different to that of an airline. Here are some examples of how you might be using hedging in your forex trading strategy.
Forex Hedging Example
As a Forex trader, you will often find yourself in a position that is in a pullback. One way to resolve the situation is to exit the trade and cut your losses. Closing a trade at a loss is definitely not an ideal solution if it can somehow be avoided.
What if you’re still confident the trade idea is valid except you had misjudged the entry point and still expect a pivot, just at a further point. One thing you can do is hedge your trade. As you do this, the position will gain profit when the market moves away from your original position, due to the hedge.
The benefit of this tactic is while the first trade is becoming increasingly unprofitable, it consumes more and more margin from your account. The second trade, however, will be returning margin to your account due to the positive P&L. As one trade is losing money, the other trade is making money.
Ideally, you would close the second trade before the market pivots and follows your initial trade idea. If everything went according to plan, you would have reduced any chance of getting stopped out and made a profit on two trades, not just one.
The Risks of Hedging
Now you know what is hedging in forex, don’t think you can minimise your risk to a point where you will never lose a single Pip, that’s impossible. Hedging is not the answer to everything. If you do not learn how to use this strategy, and more specifically when to use it, then chances are, you will often find yourself nursing two unprofitable positions, not one. Markets go up and down, even when you’re right, they can go the other way.
You should rely on various technical analysis tools to determine if there is an opportunity to hedge. The litmus test is not merely listening to your gut, telling you not to lose money. There should be a sound basis behind any decision to place a trade; you should exercise even more caution if you already have an unprofitable one on your hands.
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