What is hedging in forex and how does it work?

What is hedging in forex and how does it work?

Many forex traders use hedging as a part of their regular trading strategy to gain better control over their risk/reward ratio. It is also touted as a great technique for insurance against unpredictable and steep price movements.

What is hedging?

Hedging is primarily a risk management strategy, and it is to offset losses in investments, taking an opposite position in a related asset. They can apply to different types of trading of different products, particularly in the forex market. This is because, in forex trading, currency pairs are bought and sold as a pair.

When you buy (or go long) EUR/USD, you are essentially selling US dollars while you are buying Euros. When you sell (or short) EUR/USD, you are selling Euros and buying US dollars. This means that should one of the currencies appreciate or depreciate against your prediction, you may be at risk of incurring a loss.

To hedge a forex trade, you will open another position that inversely correlates with your first one to offset the losses you are incurring or envision you are about to incur. This could be the inverse of the same currency pair you are holding, and it is called a direct hedge. You could also hedge with another currency pair, as know as a complex hedge.

An example of hedging in the forex market

For instance, you bought EUR/USD thinking that the US dollar will depreciate and the Euro will appreciate shortly. This is because you’ve heard that the EU is making a new trade deal with Japan that could bode very well for EU-JP trade. However, at the last minute, Japan cancels the deal with the Eurozone and ends up making a better deal with the US. Suddenly, the US dollar begins to rise and the Euro begins to dip. You decide to hedge this loss.

You may, at this stage, perform one of two actions:

Open another position selling EUR/USD. In this case, you know you are losing money on your first position buying EUR/USD, but you can offset that loss with this second position. If you plan the timing of your hedge well, you can look to break even and incur very little to no loss at all.

Alternatively, you can take advantage of the fact that the US dollar is rising by opening a new position and selling your Canadian dollars for US dollars. In this case, you will sell CAD/USD. This way, when you lose money on your long EUR/USD position, you will also make back some of the losses you incurred with your short CAD/USD position.

Things to consider when hedging

Novice traders who are just getting started in trading are not supposed to use hedging, as it is a relatively risky technique if you are not well-versed in the market.

However, for those who have a bit more experience and want to minimise risk, they should keep in mind that most hedges are for the short term. Usually, they are used during brief moments of volatility around news releases, political turmoil, or market gaps over weekends. The reason for this is because while hedging is a great technique to protect against risks, they also lower potential profits.

How to exit a hedge

When exiting a hedge, you can choose to close one or both positions. If you want to keep your initial position open, you can close your second one at any given time. However, if you want to close both positions, you need to ensure you close them simultaneously.



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