A Perfect Guide To Hedging
Hedging in a layman’s vocabulary is referred to as trimming the bushes to form a hedge but when it comes to trading, hedging is a crucial term that refers to a risk management strategy that protects one’s position in a currency pair from an adverse move. It is mainly referred to as short-term protection that protects the trades while any news release or event triggers volatility.
What is hedging?
Hedging is a financial trading strategy that helps in protecting the trader’s funds from exposure to risky situations that might lead to losses. It involves opening a position with a currency pair that could counteract the possible movements of other currency pairs. In hedging, the position size of both the currency pairs is the same and the price movements of both currency pairs are inversely correlated, which means that the price change in these currency pairs can cancel out while the positions are active.
How does Hedging work?
There are basically two approaches for hedging: The first approach is to take a position on the opposite side in the same currency pair. Then, there is a second approach involving opening two opposite but with the same size the positions of highly correlated currency pairs. In forex trading, it is important to know both.
1. Direct hedging: Some forex brokers allow traders to place direct hedge transactions. Direct hedge traders place a deal with one currency pair and are also permitted to place sell transactions simultaneously. Eg. a trader will go both long and short with a currency pair, let’s say EUR/USD. The net profit of the trades becomes zero and if a trader is able to time the market properly, he can reduce additional risks and make more money.
2. Complex hedging: Another approach for hedging is by selecting two currency pairs that are favorably correlated. For eg. EUR/USD and GBP/USD. Open the positions with both the currency pairs but on opposite sides. Suppose a trader opens a short position with EUR/USD and wants to balance the exposure of USD so, he goes long with GBP/USD. If the Euro fell against USD, he might lose money on GBP/USD position. But this is balanced by the profit on his EUR/USD position. If US dollars declined, hedging would compensate for the losses if you go short.
While leaving a direct or complex hedging position, keep the initial position open and only the second position must be closed. While closing out the ends of the hedge, traders prefer closing them simultaneously to avoid any potential losses incurred by any kind of gap. It is important to track the hedging positions so as to exit the position at the right moment. One underlooked position might fail the whole hedging plan.
Despite being an effective trading strategy, not all brokers allow it. Some that do include;
Hedging is mostly applied by experienced traders because they have the required knowledge to create an effective hedge, but beginners can also implement this strategy to manage risks while trading. Forex hedging strategy is one of the most potent ways of anticipating the market movement and choosing the right moment for entering the trade.
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