Hedging is one of the most widely applied trading strategies in the forex market. It can act as a powerful risk management technique. But with all the other tools and techniques of risk management, why do you need another one?
The forex market is among those markets that exhibit the highest degree of fluctuation and volatility in the short term time frame. Whereas in other markets, you can almost see changes coming in the long run, the forex does not work that way. Price movements can be quite sharp and sudden.
Therefore, in order to protect your position and your assets in the market, you can use the strategy of hedging. In this article, we are going to take a look at this strategy, and see what hedging is, how hedging works, and how you can employ hedging in the forex market.
What Is the Definition of Hedging?
When you have an open position in the market, and that is any financial market, your open position is by definition open and exposed to outside factors. Among the most important factors that can impact your position are, for instance, news events that can change the direction of prices.
There are naturally countless other forces that work together to shape the movements that take place in the market. Whatever they may be, the fact is that your open position is exposed.
Precisely because of this exposure, you need to take the necessary steps to protect your position. There are many strategies that are useful for this exact purpose.
Among them there is one particular strategy that is very well suited to this condition – namely hedging.
Hedging is a trading strategy in which the trader will open another position(s) contrary to the existing one in order to neutralize the opposing impact that might affect your original position.
For this reason, it is also said that a hedging position also has a negative correlation to the original position. This is because of the anticipation that if and when an outside force impacts your original position and pushes it toward loss territory, your hedging position will cancel out the opposing force and create a balance.
Now keep in mind that hedging strategies, as mentioned at the beginning, are risk management strategies. So do not expect to use them in order to increase the profits that you will potentially earn. They are only a means of protecting your assets from loss or at best ensuring that the projected profit goals will be held as they are.
Of course hedging is implemented in all markets. But we are going to particularly focus on the forex market.
How Does Hedging Work in Forex?
An interesting perspective to look at how hedging works in forex is to think of buying a warranty for a product that you have purchased. The thing with warranties is that you have to make the payment upfront, and depending on the product, the amount that you pay might seem unreasonable to you.
But if you are a cautious consumer, you would pay the price at first, so that in case anything goes wrong in the future, you have the warranty to fall back on.
The same is true with hedging in the forex market. A hedging strategy is similar to paying for a warranty for a product. Just like the warranty, your hedging position is basically money you have lost. But it will protect your product (the original position in the forex market) from unfavorable conditions that may or may not occur.
What Are the Benefits of Hedging in the Forex?
The important point that you need to remember about hedging is that all market participants might use it. So, contrary to popular belief, hedging is not only used by big market participants such as institutional traders and hedge funds. Individual traders alike also implement this risk management strategy.
The main benefit of using this strategy is to make sure that the current status of your position will not undergo change no matter what happens in the market. This applies to both profit and loss.
This means, if your position has yielded a certain amount of profit, then you can use hedging to make sure that the projected profits will eventually be obtained from the original position.
On the other hand, if your position has incurred losses, it is imperative that you take the necessary measures to make sure losses do not continue amassing. Obviously, one such strategy is hedging. And in this way you can make sure that the losses that you have sustained will not increase more than what they are.
As we already discussed, your open position is an exposed position. Of course there are events in the market that are outside of the control of any one trader. We mentioned the example of news events that can change the direction of the market.
But there is another particular situation in which hedging can be quite useful. Imagine you have an open position, but certain events and newly obtained information bring doubt to your mind with regard to the future of the market.
At the same time, you do not want to act hastily and close your position quickly and prematurely. In this situation, you might want to use a hedging strategy to give yourself some time to examine the situation a bit longer and make a more well-informed decision.
How Can You Use Hedging in Forex?
Now that you know exactly what hedging is and why it is applied by traders, let’s see how you can use this strategy in forex trading with a clear example.
Remember that we said in its essence hedging is opening a position with a negative correlation to the original position.
So imagine you have opened a long position with the forex trading pair EUR/CHF.
In this situation you have taken a long position on the Euro. This means you are betting in favor of the Euro and against Swiss Franc in this situation. Your original position is one in which you expect the Euro will gain in value against Swiss Franc.
Now, if you anticipate that your long position in this case might be in danger of unfavorable market movements, you can hedge another position against your original position.
Because you have longed for Euro and basically shorted Swiss Franc, you can open a position with exactly opposite features. You can also open another long position with the Swiss Franc as the base currency.
In either case, you can see that you need to open an opposing position to your position to make sure that even if things in the market do not move toward your predicted direction, you will still not sustain much losses.
Hedging is basically a risk management strategy in which a trade will open a new position that stands in almost exact opposition to the original position. This way, if the original position undergoes losses, it will be balanced out by the new opposing position.