What is forex hedging?
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The term hedging often appears in forex transactions. Forex hedging is a trading method entering opposite orders on the same currency pair to limit the risk to the lowest level. So what is forex hedging?
What is forex hedging?
Forex hedging is a trading method in which a trader trades the same currency pair with the same volume but two opposite orders. When the price goes against the predicted direction, the trader closes the position and waits for the remaining position to return to breakeven or until profit.
Example: Trader buying 0.5 lot EURUSD and selling 0.5 lot EURUSD means hedging 0.5 lot.
What are forex hedging strategies?
There are many methods to manage trading risk, and hedging is one of the most popular.
There are two forex hedging strategies, including simple hedging and multi-currency hedging.
Simple Forex Hedging
Some brokers allow traders to open positions as direct hedging. Direct hedging opens a long position on a currency pair and simultaneously opens a short position on the same currency pair.
The profit when opening two trades will be zero. Investors can make more money without taking the additional risk if they choose the right time to enter the market.
The advantage of using hedging is that the trader can hold the first position and make money with the second position making a profit as the market moves against the first position.
If the trader suspects the market has reversed and returned to the original position, the trader should place a stop-loss order on the hedging trade or close the order.
There are many forex hedging strategies out there, and they can get quite complicated. Many brokers do not allow traders to use hedging in the same account, so other approaches are needed.
Multi-currency hedging strategy.
Traders can be hedging for a specific currency using two different currency pairs. For example, a trader buys a long EUR/USD position and a short USD/CHF position. If the Euro strengthens against all other currencies, there can be volatility in EUR/USD that is not counterproductive by the trader’s USD/CHF trade.
Hedging multiple currency pairs also comes with its risks. If the hedging strategy works, the investor’s risk is reduced, making a profit. With a natural hedging strategy, net balance = 0. However, with a multi-currency Forex hedging strategy, one position will likely generate more profits than losses from another position.
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Some notes before using Forex hedging strategy
- Not all brokers allow traders to use hedging in trading.
- Using hedging, the trader will incur two spreads due to opening two orders at the same time.
- There is no guarantee that currency pairs will be 100% inversely correlated. There will be a small probability that both orders will be inversely correlated with the prediction.
- Traders should consider using hedging on low-volatility currency pairs to minimize risk.
Forex hedging is a hedging method, but the trader will also have to pay a cost in executing two positions simultaneously. This transaction fee will be incurred when the trader trades more. Forex hedging strategy will help investors protect their capital account when the market moves against the trend. However, if the market goes in the right direction, the trader also loses a significant profit.
To make a profit, traders should consider using a reasonable Forex hedging strategy against large fluctuations from the market.
What are mistakes when using hedging forex?
These mistakes often appear to newbies or inexperienced traders.
Cannot identify the trend field and hedging chaotically
The price fell after placing a buy order, but they did not dare to cut their losses. Fearing that the price would continue to fall, they entered a sell Hedging order. Usually, the price will continue to fall, and they will close the sell order for a small profit. However, there are a few cases where the price drops until they burn out the buy order. For such cases, hedging is just in time for the price to rise.
Such hedging makes traders lose direction and continuously enter buy/sell orders. Doing so will cost traders many trading fees.
Use an unwarranted hedging strategy.
Traders who use hedging strategies do not follow any basis. They constantly enter buy/sell orders. When an order has a little profit, close the order. At that time, all results of closed positions were profits. However, the unclosed trades are making more significant losses.
When the losses are closed, the small profits do not make up for it.
The article introduced what forex hedging is? Hedging helps traders protect capital when the market moves in an unfavorable direction. However, when it goes according to the prediction, the trader loses a profit. So use a sound forex hedging strategy against big swings.