Introduction
Hedging is one of the well-known forex trading strategies traders use to reduce risks associated with foreign currency exchange. This method protects the trading profits against market fluctuations by opening additional positions to counterbalance the losses and risks associated with forex trading.
However, hedging can get complicated and challenging to navigate. Understanding the basics, hedging strategies and how to implement these strategies are essential. In this guide, we will help you understand everything about forex hedging.
What is Hedging in Forex?
Hedging can be defined as a backup plan or strategy which involves opening a new market position to reduce the risks of exposure to currency fluctuations. It also includes simultaneously opening long and short positions on an adjacent currency pair to reduce risks and protect profits. For example, if a trader has placed a long position on the EUR/USD currency pair and then simultaneously opens a short position, the trader uses the hedging technique.
What are Forex Hedging Strategies?
There are many different forex hedging strategies that you can use to cut down on your losses and increase the profit margin. Some common strategies are as follows:
Direct Hedging
This forex hedging strategy is a guaranteed profit as it directly places opposite positions on a single currency pair; for example, you put long and short for both EUR/USD currency pairs. Although there is no net profit with direct hedging, the original trading remains intact and prepared to handle any price fluctuations or market reversals.
This strategy allows you to have a second chance at trade. For example, if your position does not profit, you can hedge the position and make money with a second trade. Very few brokers provide a direct hedging strategy. Amongst those who do, TradeEU is a great choice because of its feature that allows you to hedge from your initial trade as well.
Multiple Currencies Hedging
Unlike direct hedging, which includes opposite positions on a single currency pair, this forex strategy includes multiple currency pairs. You can select two correlated currency pairs and trade in opposite directions to minimise risk, giving you a 50% chance of gaining profit.
Suppose you trade opposite on two USD currency pairs – EUR/USD and GBP/USD, and long and short positions on the pairs, respectively, so if EUR falls in value against the US dollar, you can earn profit from the other currency pair.
Options Hedging
Options are contact with underlying assets which traders can trade on, and they are convenient assets because they allow traders to exchange currency pairs without obligation. So, you can hold an asset until it expires, giving you a long time to use it. You can use hedging to stop or hold the currency pair when its value declines. Then, you can let the currency pair expire or trade when the market improves.
How to Hedge in Forex Trading?
To successfully conduct hedging in forex trading, follow the below steps. You can also download the Forex hedging strategy pdf from free websites.
- Identify the Risk: It includes analysing how certain pairs react to market fluctuations and planning risk management strategies per the requirements.
- Choose a Hedging Instrument: Some common hedging tools are options, forward contracts and futures.
- Selecting a Trading Strategy: It depends on personal preference whether you want to use direct hedging using one currency pair or multiple currency pair hedging using two correlated pairs.
- Decide Positions: The next step is to decide which position you plan to place your asset in. It is very important to carefully analyse the currency value in the market using market analysis tools like the economic calendar, etc. Capitalix Broker offers a great set of technical and market analysis tools.
- Manage Portfolio: Since hedging involves opening new accounts and trading with multiple currency pairs simultaneously, it gives a scope for portfolio diversification. You must manage your portfolio efficiently to track what assets and accounts are involved and affected by market fluctuation.
- Monitor: Now that you have used hedging on your active assets, it’s essential to keep track of your assets and the market and make adjustments accordingly.
Risks Associated with Forex Hedging
Hedging is a two-way sword with pros and cons that can affect a trader’s performance. Risks are very common in hedging. Some of them are as follows:
- Reduced Profit: Hedging is adopted by a trader to reduce potential risks by balancing and dividing their assets. But this way, the profits are divided and do not include the highest profit potential. So, those who are willing to take huge risks are the ones who gain maximum profit potential.
- Mental Health Impact: The hedging strategy forex is not easy to navigate and might require traders to pay close attention to the market’s constant fluctuations. This constant pressure can create an unhealthy psychological impact and induce more stress than usual trading does.
- Complicated: This risk management strategy is effective but very complicated to understand, and things can go wrong when you do not understand positions, order execution, and market dynamics.
- You can implement this strategy if you are an experienced trader looking to reduce your trading losses. But if you are a novice trader, it’s essential to understand the basics first.
- Increased Cost: As part of the hedging strategy, traders must use certain hedging instruments like options, future, etc., which can potentially increase the cost and further reduce the profit margin.
Consider these points before using hedging in your trades and understand your risk-bearing potential.
Hedging Vs Speculation
In forex terminology, “hedging” and “speculation” are frequently mentioned, yet they carry distinct meanings. Hedging involves mitigating potential losses by taking a position opposite to the primary trade, aiming to neutralize risks in forex markets.
On the other hand, speculation entails holding a position with the expectation of profiting from fluctuations in the price of a financial asset. For instance, if one foresees the euro strengthening against the dollar, they would buy euros and sell dollars. Similarly, an investor might perceive an asset as undervalued and purchase it, anticipating a future increase in its value.
A crucial difference lies in the objectives: speculators seek profits, while hedgers aim to safeguard against adverse outcomes. Consequently, speculators face vulnerability if their predictions don’t align with the market, potentially leading to losses.
Best Forex Hedging Brokers
Hedging is a popular trading strategy traders have used for a long time. Therefore, many forex brokers offer this strategy to attract more traders to their platforms. We have listed some of the most common and popular forex brokers that allow hedging:
FP Markets
This broker is known for its high liquidity, allowing traders to enter and exit market positions easily while causing minimum slippage. It offers hedging on various assets, including gold, etc. and provides educational materials like summaries and articles on hedging on the broker website.
AvaTrade
AvaTrade is a South Africa-based forex broker that allows various trading strategies like scalping, hedging and netting. This broker allows you to trade on different positions on the same asset and hedge without limitations. The various asset options offered by AvaTrade are a great perk for forex trading hedging.
Moreover, the platform offers plenty of free educational materials on hedging, making it one of the best hedging forex brokers.
eToro
This Israel-based, highly regulated online forex trading broker offers various tradable instruments. The best part about this broker is that it offers low-risk assets like ETFs that are usually required and can be used in hedging.
FAQs
What is hedging in Forex?
Hedging is a risk management strategy that can be implemented by traders to reduce risks and protect profits. Different strategies for forex hedging include placing opposite positions of related currency pairs to balance the profits and losses incurred.
Is Hedging allowed in Forex?
Yes, hedging is legal, and traders can use it in forex trading. However, it is important for traders to note that hedging has certain disadvantages, which can affect trade performance and reduce profit potential.
What does hedging mean in Forex?
In simple words, hedging, meaning in Forex, is risk management. Traders use this great strategy to minimise risk and protect assets against market fluctuations.
What is Forex hedging?
Hedging in forex is a risk management strategy that balances and navigates trade positions to protect profits and reduce risks.
How to do hedging in Forex?
Use hedging strategies forex to Identify risks, choose hedging instruments, select a strategy, and decide positions. Manage the portfolio and monitor the market to observe your trade positions.
Is hedging in Forex illegal?
No, hedging is not illegal and is used by traders worldwide.
What Forex brokers allow hedging?
Brokers like FP Markets, AvaTrade, IC Markets, FXTM and eToro are some of the best hedging forex brokers.
What are Forex hedging techniques?
Some well-known forex hedging techniques include direct hedging, multiple currencies, and options hedging.
What is Forex broker hedging?
Certain brokers, such as FP Markets and AvaTrade, are known for offering hedging services to traders.
