What exactly is Forex hedging?
Hedging is a forex trading strategy that involves taking opposing trades in order to offset risk and limit losses that will be incurred on a given trade. Hedging with forex is used to protect one’s position in a currency pair from an adverse or unfavorable market movement. It is akin to having insurance upon your trades because it helps to recover the losses that could potentially result.
This strategy is used by both new and professional traders and ensures that the risk is mitigated. Most traders and investors will seek to find effective ways to limit the potential risk exposure of trade, and hedging is just one of the strategies that they can use.
How to hedge in forex trading
1 Open a Forex Trading Account
Before hedging forex, you need to open a forex trading account. Make sure the trading platform permits hedging and has the specific asset or currency pair that you want to hedge. Some brokers don’t allow traders to hedge, and you can find this information on the brokerage platform. Many US brokers don’t permit hedging due to the local and national regulations by the regulatory agencies in the country. But, you can open two separate trading accounts and hedge your trades with both accounts.
Remember, hedging requires you to open a new trade position, so make sure your leverage and trading capital are sufficient for a hedge to be executed.
2 Choose a currency pair
Once you’ve opened a trading account, you can decide which pair to hedge. There are 3 types of currency pairs; major, minor, and exotic pairs.
Major currency pairs are pairs that contain the US dollar as the quote or base currency. Examples include EUR/USD, USD/JPY, and NZD/USD.
Minor currency pairs consist of currencies of major economies that don’t include the US dollar, such as NZD/JPY and EUR/CAD.
Exotic pairs are created by pairing currencies of emerging economies with that of developed economies. These emerging economies include Rwanda, Mexico, South Africa, and Norway.
There are several tradable forex currencies so make sure you choose a pair that suits your trading style and needs. If you want to take advantage of market volatility, you may want to choose a foreign currency that is liquid and volatile.
3 Determine your forex hedging strategy
There are many hedging strategies available today, and you can use any of them to hedge the forex market. Some of them have been discussed in this article. Choose a strategy that best mitigates your losses and reduces your risk.
4 Keep up to date with the news
News and economic data can influence your hedge trades. Make sure you keep up with the news and carry out fundamental analysis while taking these trades. Analyze the political and economic situation in different countries and use that to huge the potential strength or weakness of the currency.
5 Carry Out Technical Analysis
Technical analysis is crucial to the success of your trades. It helps you to determine the best entry and exit points for your trade. Getting optimum entry points can help you to maximize the potential of your trading strategy and increase the likelihood of success.
6 Use Proper Risk Management
Risk management ensures that your hedge trade can effectively mitigate and offset the risk of your trades. Use a stop loss order to predetermine and limit your losses because this can protect your capital.
Top Strategies to Use in Hedging on Forex
A simple forex hedge involves opening opposing trades on the same currency pair. For example, if you buy EUR/USD, then you can open a sell trade on the same pair to offset any risk that you would incur if the buy trade turns out to be unfavorable. This is the most common hedging style and is available on many brokerage platforms. This is a direct hedge.
Simple forex hedging strategy
Without a direct hedge, the initial trade will result in a loss of capital. This style of hedging would enable you to make money with a second trade as the market moves against your first.
Hedging with correlated pairs
In forex trading, your risk can be offset by hedging with correlated currencies. Currency Paris like AUD/USD and NZD/USD are strongly positively correlated. Taking a buy trade on AUD/USD and a sell trade on NZD/USD is a way of hedging your US dollar risk exposure. The positive correlation means that these currencies tend to move in tandem. This style of hedging isn’t as efficient as the simple forex strategy because, despite the correlation between two currencies, there is a chance that they will generate different profit amounts.
3 Hedging with Forex Options
Forex options are currency derivatives that give you the right but not the obligation to trade currencies at a predetermined price.
The options contract can end in a profit or loss at the end of a specified time period known as the expiration period. FX options can be a great way to diversify and even hedge an investor’s spot position. The options contract can be a ‘call’ or ‘put’ contract, depending on the trader’s speculation about the price level at the end of the specified time period.
Is hedging a good strategy in forex?
Hedging is a forex strategy primarily aimed at risk offset and mitigation. Just like other forex strategies, hedging is a good strategy if you learn how to apply it correctly.
3 Reasons to Hedge in Forex Trading
To diversify the trading portfolio
Hedging can be done with various currencies and assets, as explained in this article. This helps to diversify your portfolio and prevent irreparable losses that can occur otherwise. If you hedge one currency pair with another correlated currency, you spread out your open positions to reduce the risk of having a single event wipe out your account.
To mitigate and offset the risk
The main aim of hedging is risk mitigation, control, and management. It ensures that your capital is protected against huge losses since you have an opposite trade that will make up for it. However, make sure you learn a hedging strategy before attempting to hedge on a live trading account.
To protect your account
The forex market is prone to random price fluctuations and volatility spikes. This can occur during news events and highly volatile market hours. During news releases, the forex market is prone to prove gaps that can make it difficult to manage risk on one trade. Hedging your trades ensures that even when price gaps occur, your account will be protected.
Try out DecodeFX and find out more about Forex hedging
Now that you understand how hedging works, you can open an account on a forex trading platform and execute your trades. Before doing so, make sure you’ve learned a reliable strategy that will produce favorable outcomes for you.