How To Reduce Forex Risk Through Hedging
Hedging is a common strategy used by forex traders to limit the risks associated with some of their trades. Forex hedging strategies rely on positions opened by a trader in order to reduce their overall exposure to changes in prices of a given currency pair. Although hedging strategies are usually employed to limit a trader’s risk, it is important to incorporate technical and fundamental analysis within any hedging strategy in order to make it effective. The best forex hedging strategies limit risk, but also take a cut of your profits. You can think of this as taking an insurance premium on your positions.
Hedgers Vs. Speculators
A hedger’s primary motivation is to reduce the risks associated with price movements in the instruments they trade. On the other hand, a speculator takes positions in a given market with the primary motivation of making a profit from future price movements.
Hedging is largely a way of buying insurance against price movements that do not favor your current and future positions. As we’ll see, forex traders also use hedging as a way to generate potential profits.
Achieving Market-Neutral Positions
Achieving market-neutral positions through hedging usually involves identifying two currency pairs that are positively correlated, and initiating opposite trades in each of the currency pairs. Examples of positively correlated currency pairs include the EURUSD and GBPUSD, as well as the AUDUSD and the NZDUSD.
The most important aspect of hedging is to choose two correlated pairs that move somewhat asymmetrically to each other. For example, when trading the AUDUSD and NZDUSD currency pairs, you take opposite positions across the two pairs as a hedging strategy. In this instance, as the NZD is a less volatile currency, you have to compensate with a larger trade size as compared to the opposite AUD trade.
A Word Of Caution
There are some retail traders who use hedging strategies to minimize existing loses on a losing trade. For example, if a trader has entered into a losing EURUSD long trade, they might decide to open a short EURJPY trade in order to mitigate their losses by booking some gains from the short trade.
However, opening a hedging trade to minimize the losses from a losing trade is very risky given that such a trader could ends up compounding the risks associated with their trades. In the above example, by opening a EURJPY short trade, the trader is now exposed to fluctuations in JPY, USD and EUR.
Hedging Strategies On The Same Currency Pair
Hedging on the same currency pair is an advanced strategy based on executing different types of trades on the same pair using different lot sizes to minimize losses and maximize profits. This strategy is best suited for intermediate and advanced forex traders.
Here’s an example of such a strategy. A trader buys 0.1 lots of the EURUSD currency pair at 1.2130, after which they quickly opens a sell stop order of 0.3 lots on the same pair at 1.2100. This would protect them regardless of the direction in which the currency pair moves.
In this instance, if the currency pair does not rally to the initial profit target of 1.2160 for a 30 pip gain, but instead declines to a low of 1.2070, they would still profit. This is because the sell stop order becomes an active sell order once the pair breaches the 1.2100 level.
This article provides a brief overview of the different hedging strategies that you can use when trading the forex markets. Hedging is an essential skill to learn in order to limit the risks associated with your open positions. Through a Demo account, you can test these strategies before applying them to live trades.
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