Investors of all stripes use hedging as a strategy to protect one position from adverse price movements. Typically, hedging involves the opening of a second position that is likely to have a negative correlation with the primary asset being held, meaning that if the primary asset’s price makes an adverse movement, the second position will experience a complementary and opposite movement that offsets those losses.
In forex trading, investors can use a second pair as a hedge for an existing position they’re reluctant to close out. Although hedging reduces risk at the expense of profits, it can be a valuable tool to protect profits and stave off losses in forex trading.
Understanding the Basics of Forex Hedging
Forex hedging involves opening a position on a currency pair that counteracts possible movements in another currency pair. Assuming the sizes of these positions are the same, and that the price movements are inversely correlated, the price changes in these positions can cancel each other out while they’re both active.
Although this eliminates potential profits during this window, it also eliminates a risk of losses.
The simplest form of this is direct hedging, where traders open a buy position and sell position on the same currency pair to preserve whatever profits they’ve made or prevent any further losses. Traders may take more complex approaches to hedging that leverage known correlations between two currency pairs.
Creating Complex Hedges in Forex
Because complex hedges aren’t direct hedges, they require a little more trading experience to effectively execute them. One approach is opening positions in two currency pairs whose price movements tend to be correlated.
Traders can use a correlation matrix to identify forex pairs that have a strong negative correlation, meaning that when a pair goes up in price, the other goes down.
The pairing of USD/CHF and EUR/USD, for example, is a great option for hedging because of its strong negative correlation. By opening a buy position on USD/CHF and a short on EUR/USD, traders can hedge their positions on USD to minimize their trading risk.
Trading with forex options also creates hedging opportunities that can be effective when utilized in specific circumstances.
When to Consider Hedging
Hedges are useful whenever you’re looking to maintain an open position on a pairing while offsetting some of your risk in that situation.
A short-term hedge can be a great way to protect profits when you’re unsure of certain factors that could cause volatile price movements. This uncertainty can range from a suspicion that an asset has been overbought to concerns that political and/or economic stability could cause certain forex pairs to plummet in value—particularly when you’ve opened a long position on those pairs.
Traders often use hedges to protect against short term volatility of economic new releases or market gaps over weekends.
Traders should keep in mind that as hedging reduces trading risk, it also lowers your potential profits. Because of the low returns created by hedging, this strategy works best for traders who are working the forex market full-time and/or have a large account to generate big monetary gains through limited-percentage profits.
Always Be Aware of Risks When Hedging
Although forex hedging is typically used to limit risk for traders, poor execution of this strategy can be disastrous for your trading account.
Due to the complexity of hedging in forex traders can never be fully assured that their hedge will counteract any possible losses. Even with a well-designed hedge, it’s possible for both sides to generate a loss, even for experienced traders. Factors like commissions and swaps should also be carefully considered.
Traders should not engage in complex hedging strategies until they have a strong understanding of market swings and how to time trades to capitalize on this price volatility. Poor timing and complex pairing decisions could lead to rapid losses within a short period of time.
Experienced traders can use their knowledge of market swings and the factors affecting these price movements, as well as strong familiarity with the forex correlation matrix, to protect their profits and continue creating revenue through the use of timely forex hedges.
The information provided herein is for general informational and educational purposes only. It is not intended and should not be construed to constitute advice. If such information is acted upon by you then this should be solely at your discretion and Valutrades will not be held accountable in any way.