Traders of the financial markets, small or big, private or institutional, investing or speculative, all try to find ways to limit the risk and increase the probabilities of winning. There are many Forex trading strategies out there and hedging strategies is one of them. In fact, hedging is one of the best strategies to do just that, that's why many large institutions require it as a mandatory component in their tactics.
There are even investment funds that are named after this strategy because they 'hedge' most of the trades and so they are called 'hedge funds'. In most industries, in order to limit the risk of loss, you should buy insurance. This applies to the financial markets as well, but in order to avoid the insurance fees, the hedging technique has been developed. The futures market was founded in the 19th century to protect the traders from potential losses due to price fluctuations of the agricultural commodities.
To hedge means to buy and sell at the same time or within a short period, two different instruments either in different markets, like options and stocks, or in just one market such as the Forex market.
In Forex, hedging is a very commonly used strategy. Hedging is meant to eliminate risk loss during times of uncertainty and it does a pretty good job of that. But safety can't be a trader's only concern while trading, otherwise it would be safest not to trade at all. That's why we use technical and fundamental analysis to make the hedging strategy profitable, not just safe.
This is where the analytical ability that will make you a profit while you take opposite positions on correlated pairs will come into play. When deciding to hedge, a trader should employ analysis to spot two correlating pairs that will not act exactly in the same way to the upside or downside movement. As they say, a picture is worth words, so let's illustrate the hedging benefits and scenarios with some real charts and events that have happened in the recent past. Examining the charts above, we can see that at the beginning of May both Euro and Pound were at big round levels against the Dollar, 1.
A short on both pairs seemed reasonable at those levels. But it would be too much of a risk to enter 2 short positions on correlating pairs or even one if the short didn't work out. So we would have to analyze which of these pairs was the weakest so we could hedge, short that one and enter long on the other.
Adding to that was the data and macro-economic outlook between Euroland and Britain. Europe is still struggling and the data hasn't been impressive lately, while the UK is on fast expansion, data has been exceeding expectations and rates raise is on the agenda of BOE. Almost at the same time, both pairs reached the peak and started falling quickly. Looking at the same charts again, after completing the retrace and forming a base around 1.
So pips with standard lots would have made us a 2, USD profit. If they both continued to fall, the Euro which we shorted, would fall harder.
Meanwhile, GBP which we longed, would see smaller losses, so we would still be in profit. That is the whole point of hedging, smaller profits, but no losers.
We can, of course, increase the profits by increasing the size of trades. So after the retrace on the weekly and the daily charts about weeks ago, the uptrend was about to start the next leg up. The best option would be to take a long on NZD. But to be safe, in the case of failure to continue the uptrend, we take a short on AUD. If the pairs were to fall, AUD which we sold, would fall harder since it's more vulnerable and NZD, which we bought, would see a smaller decline.
So the loss on the latter would be smaller than the gain on AUD and that would give us a profit nonetheless, even if we were wrong about the uptrend. If we were right, the NZD long would see bigger gains than what we would lose on the AUD short, so we would still be left with a profit. That leaves us with a pip profit. When hedging we have to compensate the less volatile pair with a bigger size.
To summarize, hedging is not a strategy for predicting which way a certain currency pair will go but rather a method of using the market to your advantage, even if you don't know.
Hedging strategies provide an 'insurance policy' for trading on the Forex market and if you do it right you can guarantee that you never lose another trade again. In order to use the hedging trading strategy, other Forex trading strategies must be put into play in order to understand the different possibilities. Check out our ' Forex Trading Strategies' page to learn more about all the Forex trading strategies that you should know. How to Trade Forex. What is Social Trading?
Fundamental, Technical, Popular and General Articles. Hedging - Forex Trading Strategy Traders of the financial markets, small or big, private or institutional, investing or speculative, all try to find ways to limit the risk and increase the probabilities of winning. Check out our successful live forex trading signals Get your premium signal alerts.More...