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Trading forex is often perceived as a financial activity similar to gambling by people unknowledgeable about the market. Because of this misconception, many dive into forex trading without knowing the basic concepts, strategies, and information on how the market works. As a result, many people have tremendous losses in forex by going “all in” without realising it’s not like gambling.
Many don’t understand that forex trading involves learning, understanding, and adapting to the ever-changing conditions of the market. Forex traders curate trading strategies and plans that help them position their portfolios better and ensure that the success probability of their investments is high. They do that by using techniques to protect themselves from the volatility of the forex market. One of which is by hedging.
What is hedging?
Professional traders define hedging as buying or selling securities to protect traders’ funds in case their other positions have losses when price fluctuations happen. Investopedia compares hedging to an insurance policy because it’s a strategy that protects traders as a way to mitigate potential losses.
It’s important to note that hedging only protects you from losses and tries to minimise them. But hedging could not stop any losses from occurring because it’s inevitable from happening, considering that the forex market’s volatility rate is high. Indeed, hedging is a risk management strategy to mitigate any loss to your position.
Hedging strategies
There are various hedging strategies that many professionals share. Those strategies vary depending on a trader’s trading preferences, positions, and habits. But in this post, let’s discuss the strategies many traders consider effective.
Strategy 1: Simple Forex Hedging
According to FBS.com, the Simple Forex hedging strategy is the most straightforward method. Simple forex hedging is the technique of opening a “hedge trade,” also known as a “second position,” in the opposite position of your initial trade. By doing so, you neutralise and decrease the chances of your initial trade from losing in case the direction of the market’s movement suddenly changes.
Here’s an example of a Simple Forex Hedge. Let’s say you buy a EUR/JYP pair at 1.2000. But after two days, you notice the pair’s value is decreasing; you know you won’t gain from it. To neutralise the amount you spent, you then open a trade and sell them at 1.1990 to make up for what you’re losing.
Strategy 2: Multiple Currency Pairs Hedging
Another hedging strategy is the Multiple Currency Pairs, where you open multiple trades for various currency pairs that correspond to each other. In this hedging strategy, opening trades for positively correlated pairs, like the EUR/USD and GBP/USD, influence their movement in the same direction.
On the other hand, with negatively correlated pairs, if the value of one pair decreases, the other automatically increases. An example of a negatively correlated pair would be the EUR/USD and the USD/CHF. Multiple currency pair hedging works better if you choose negatively correlated pairs. Doing so gives you an advantage because it allows you to “go short” on one currency pair if another pair decreases in value, which will then cause one to increase. Indeed, this strategy is ideal for limiting your potential losses.
Strategy 3: Options Hedging
Lastly is Options Hedging. Many traders say this technique is the most reliable hedging strategy in the forex market. It works by buying an options contract to acquire the right to buy or sell an underlying asset. You can only do this at a specified price within a specified time frame.
For example, if you decide to enter a long position for a specific currency pair, you can buy an options contract to sell your currency pair at a price that works for you. This is easier to manage, especially when the market suddenly moves against your trading plans.
Advantages of hedging
1 – Mitigates potential losses a trader could have
I mentioned in my introduction that hedging is a risk management strategy. Looking at its definition, it’s obvious that its purpose is to reduce any potential loss a trader could have when trading. With hedging, you can negate losses from one position by opening more and earning profits from them.
2 – Protects your trading profits
Aside from mitigating losses, hedging in forex trading protects your hard-earned profit. Having an open trading position that already has enormous profits is susceptible to losses considering the highly volatile forex market. By using hedging strategies, you protect your trading earnings and ensure your profits won’t be at stake.
3 – Saves trading monitoring time
I’ve been reiterating that the forex market is highly volatile. Because of that, traders have to monitor their positions and accounts regularly to ensure that their trades are in good hands. You get to mitigate losses, which saves you time from monitoring the market charts by using hedging strategies. If you’re using hedging strategies, you won’t have to worry about price fluctuations because you know your options are neutralised to your advantage.
Disadvantages of hedging
1 – Hedging costs could reduce your profit
Even though the purpose of hedging is to protect your profit, it can also reduce it. As professionals say, risks and rewards are proportional. If you reduce the probability of risk, you also reduce your chances for profits, especially in trading.
2 – It’s not that beneficial if the market’s condition is to your advantage
Another disadvantage of hedging is it can be unhelpful when the market’s conditions are in your favour. Hedging strategies offer minimal benefits if the forex market is performing well. That’s why, it can also be costly and unhelpful to opt for hedging techniques once the market starts performing to your advantage.
Before starting hedging, ensure the market conditions are suitable and necessary for your trading options.
Indeed, hedging has advantages that will benefit and protect your trading activities in forex. However, there are cases when your options won’t need it because the market’s data is to your advantage. That’s why before hedging, it’s best to study the market and evaluate your trading options to ensure it could benefit you.
Photo by Maxim Hopman from Unsplash
