How to Hedge A Forex Trade to Make Money in Both Directions
Hedging is a leading forex trading strategy for those who want to shrink portfolio exposure. Traders frequently choose to hedge as a way to spread out their capital and maximize the potential for profit. Hedging against movement reduces risk, and there are plenty of different hedging strategies floating around, so it’s definitely worth considering if you want to even out your portfolio.
As a trading strategy, hedging can be both basic and complex. The following will help you get a firm grasp on hedging and ways you can hedge a forex trade to make money in both directions.
Basic Forex Hedging
Hedging is the act of buying and selling the same currency at the same time. The net profit is nil while the trade is open, but if you time everything just right, you can actually make money without additional risk. A basic forex hedge will safeguard your interests by allowing you to essentially trade the converse direction without closing the first trade, so you have both open at the same time. Some argue that sense dictates you close the first trade at a loss, before placing a new trade in a more desirable position, but the opinion on this varies from trader to trader.
The hedge gives you an advantage by allowing you to keep your trade active, so you can generate money with a second trade as the market moves against the first trade. If you suspect or predict the market to reverse back in your first trade’s favor, you can close the hedging trade or set it to stop. It’s a simple analogy, but it’s like betting on both teams to win a football game. Whatever the outcome, you’ll either be making a profitor—at worst—experiencing a manageable loss.
Complex Forex Hedging
Hedging a forex trade—or multiple forex trades—can get fairly complex. Many brokers don’t allow direct forex heading, so traders must take creative approaches if they want to make money in both directions.
Utilize various currency pairs
It is possible to hedge against a currency utilizing two currency pairs at once. To describe an example, if you were to go long on CAD/USD and short on USD/GBP, you would be hedging against the USD. The only area where you are exposed is to fluctuation in the other currencies—in this example, the CAD and the GBP. So, if the CAD strengthens, there’s a chance that the short USD/GBP won’t counteract it. As a result, this is not considered a reliable hedge, unless you’re factoring into the equation a wide variety of currency pairs, which can quickly get complicated.
Engage in forex options
One option in the forex market is to agree to exchange at a price specified in the future. For example, you would place a long trade on EUR/USD at 1.35 and guard that position by placing a strike option at 1.34. If the EUR/USD falls to 1.34 within the timeframe you’ve set, you’re paid out an amount dependent on the size of the trade and conditions of the market when you buy. If the currency pair doesn’t hit that price within the time specified, all you lose is the buy price—which should prove to be a manageable loss.
Reasons to Forex Hedge
Here are two reasons why hedging tools can be important and effective ways to improve your forex trading performance.
Brexit is a great example of political uncertainty; the sheer panic that followed removed $2 trillion from market values across the world and activated one of the most volatile environments for trading in history. After Brexit, the British pound had a huge one-day selloff— the biggest in its history—and Sterling dropped from $1.50 against the USD to $1.368 in a single day. These incredibly drastic and volatile shifts occur occasionally throughout history as a result of politics, and can be almost impossible to predict, sometimes coming as great surprises. When you hedge, it is quite possible to turn major political uncertainty into profit if you are able to set your orders appropriately.
Another thing that brings about an unpredictable forex market is a major shift in economic conditions. For example, the fall of oil prices in 2014 caused an economic decline in Russia, due to the fact that crude oil is a major export of the country. The ruble (RUB) suffered a massive collapse as a result. In June 2015, turbulence in the Chinese market echoed across the globe, causing uncertainty in New York and Europe. Situations like this have the power to cause wild swings in the forex market, which makes it a prime-time period for forex hedging as a trading strategy.
The overall purpose of hedging your forex trades is to limit risk. It can be done carefully and become a big part of your trading strategy—effectively allowing you to make money in both directions—but should only be employed by those with adequate trading experience. As you’ve now been made aware, hedging places a heavy emphasis on timing, along with understanding the ins and out of market swings.