⛨ HEDGING AGAINST TRADING RISK & STRATEGY
Hedging is an investment strategy that creates an offsetting position to reduce or eliminate trading risk. It helps traders protect themselves from significant losses.
Explaining Forex Hedging
Forex hedging is a tool used to reduce risk in the Foreign Exchange market. By applying a hedging strategy, a trader holding a long position in a currency pair can protect against downside risk, while a trader with a short position can guard against upside risk.
Hedging comes at a cost, as it reduces risk but also limits profit potential. In essence, hedging acts like insurance against unexpected future price movements.
Direct Forex Hedge Order
Most Forex brokers offer the option to place a hedge order directly. This means you can buy a Forex currency pair and simultaneously sell the same pair. Profit is possible by timing your buy and sell decisions correctly.
If your broker does not allow direct hedging, alternative and more complex hedging methods may achieve similar results. However, complexity requires more time, and time is money. Therefore, the ability to hedge directly provides an advantage, which is why this option scores well in our Rating Formula.
Strict Forex Position
A strict Forex hedge involves opening a short position and an equally sized long position at the same time. In 2009, following the 2008 Financial Crisis, the National Futures Association in the United States banned this practice. Outside the US, traders can still implement this strategy using pending orders.
When you open a position in a currency pair and want to hedge against the risk of a particular currency, you may use an alternative hedging method.
For example, if you open a long position on EUR/USD and want to hedge, you might open a short position on GBP/USD, which is highly correlated with EUR/USD. This way, you hedge against USD risk but take on a new risk related to the GBP market. Therefore, these multiple strategies do not fully eliminate risk.
The advantage of Forex hedging is that it allows you to maintain your original trading position while reducing short-term market risk.
Before the implementation of a Forex Hedging Strategy
Implementing a Forex hedging strategy involves several stages:
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Risk Analysis (Identifying and Measuring Risk)
The first step for a Forex trader is to identify and analyze the risk sources within their trades. Then, the trader must evaluate the impact of each individual risk as well as the combined effect of all risks. This helps determine whether the market risk is low, medium, or high.
Note: Correlations between Forex pairs can significantly increase the overall market risk of your positions. -
Making Trading Decisions (To Hedge or Not)
After identifying the risk sources and their implications, the trader must decide whether to hedge or not. Additionally, they should determine how much they are willing to pay to hedge against the identified market risk.
Note: Verify if your Forex broker offers a Direct Hedge Order option on their trading platform.
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Choosing a Hedging Strategy (Selecting Hedging Instruments)
At this stage, the trader selects the type of hedging strategy to implement, based on the cost and effectiveness of each option. Typically, the effectiveness of different hedging strategies is similar, so decisions are mostly driven by cost.
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A Forex hedging strategy may involve full or partial hedging.
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It may also involve various financial instruments such as options, futures, CFDs, etc.
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Testing and Monitoring the Hedging Strategy
Every trading strategy should be tested after implementation. Monitoring is especially important when using the strategy for the first time.
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