Forex Hedging



A. Hedging in General


Hedging in general is an investing strategy that creates an offsetting position of a particular trade in order to reduce or even to eliminate trading risk. Hedging helps traders to protect against high losses. Hedging is costing money, so it eliminates risk but at the same time it reduces the profit potential. Hedging in a way is like purchasing insurance against an unexpected future price movement. 


What is Forex Hedging?

Forex hedging is used by traders to reduce their Foreign Exchange Risk when dealing in the market. By implementing a hedging strategy, a Forex trader that holds a long position in a currency pair, can be protected from downside risk, while a Forex trader that holds a short position in a currency pair, can be protected against the upside risk.


Direct Forex Hedge Order

Many Forex Brokers are providing the option to place a Direct Hedge Order. That means that you are able to buy a Forex currency pair and at the same time to sell the same Forex currency pair. Profit can be made by picking the right timing to buy and sell. If your Broker doeasn’t allow direct hedging some other methods of complex hedging may be used having the same results. But complexity means more time, and time is money. So direct hedging is an offering advantage and that is why a Direct Hedging option is weighed (1%) in Rating Formula.



Strict Forex Position

A strict Forex hedge means opening a short trading position and an equal long trading position simultaneously. In 2009, and as an effect of the Financial Crisis of 2008, the  National Futures Association of the United States forbade this trading practice. Outside the US, traders can still execute this type of strategy by using pending orders.


Hedging Risk using Multiple Currency Pairs

When you open a position in a Currency Pair and you want to hedge against the risk of a particular currency you may use an alternative hedging method. For example when you open a long position is EUR/USD and you want to hedge against the USD you may open a short position is USD/JPY. In that way you may hedge against USD but you are exposed to a new risk, and that is JPY currency risk (JPY). So this multiple strategy doesn’t actually eleminates risk.

Why Hedging Anyway and not Opening a new Position?

But why to hedge anyway and not just close your position and open afterwards a new one? The advantage of Forex Hedging is that you are able to keep your trading position and have a second chance to make some money in the near future.


B. Designing a Forex Hedging Strategy

Implementing a Forex hedging strategy includes several stages:

1. Risk Analysi

As a first step, a Forex trader must identify and analyze the risk sources that are incorporated in his trades. Afterwards, he must analyze the level of implications of each separated risk but also the implications of all risks combined. Then he will able to judge if the market risk of that particular risk is low, medium or high.

2. Make Trading Decisions (Hedging Yes / No)

After the sources and the possible implications of risks are defined then the trader can make his decisions. If the marker risk is too high a hedging strategy must be implemented. Furthermore he must decide how much he is willing to pay to hedge against the market risk.
-Check if your Forex Broker includes a Direct Hedge Order into his trading platform-

3. Choosing Hedging Strategy

At this step the trader must decide which type of hedging strategy he must implement. The choice is made upon the cost and the effect of each strategy. Usually the effect of all hedging strategies are the same so the decisions are made only upon cost.

4. Implementing the chosen Hedging Strategy

At this step, the decisions made earlier are transformed into an offsetting trade, in a way that a hedging strategy is implemented properly.

5. Testing and Monitoring Hedging Strategy

Every trading strategy must be tested after implementation. Monitoring a trading strategy is important, especially if you are implement it for the first time.

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Forex Hedging
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