Many forex traders believe hedging is a sure-fire way of eliminating risks from trading while optimising their returns. While that’s not entirely true, hedging does protect traders from incurring heavy losses, by placing a trade in the same market but in the opposite direction to offset any potential losses. It’s a strategy that provides a safety net against unexpected market movements, and it’s a handy one to apply in your forex trading strategy.
How Hedging Works
Forex hedging is pretty simple; it usually starts with an open ‘long’ position which a trader hedges by opening a new position that is counter to the long position’s expected movement. In other words, a hedge allows you to maintain an open position on the original trade without experiencing any losses if the price moves against your prediction. This particular type of hedging is known as Simple Forex Hedging.
Multiple Currency Hedging
There are other hedging strategies aside from Simple Forex Hedging that forex traders use to hedge their currency positions. One of those is Multiple Currency Hedging.
As the name suggests, this type of hedging is used when trading multiple currencies. In this type of forex hedging, you buy a long position in one currency pair, as well as a counteracting short position in another currency pair.
For example, you take a long position on the EURUSD market and a short position in the USDJPY market. In this case, you’ve protected yourself against the USD’s exposure. However, you’re not protected from movements in other currencies to which you may still have exposure. For instance, in the above example, you still have exposure to price movement in the GBP and JPY.
A variation on the multiple currency hedging is when you take long and short positions in currency pairs which are positively correlated. In this case, if one currency pair goes down, the other goes up. For instance, the pairs can be the EUR/USD and GBP/USD. With this variation, if you hold a buying position in one and a selling position in the other, they should theoretically offset each other.
Hedging Industry Risk
When you are hedging industry risk, you’re taking a long and short position based on upcoming industry regulations. For instance, there could be changes to the law that could negatively affect the continued existence of fuel combustion engines. At the same time, there could be upcoming regulations that promote the electric car industry. In this case, you would want to make sure you hedge your positions to ensure you make a profit no matter how the legislative process pans out.
Hedging Economic and Political events
Political and economic events can have a massive effect on currencies, and this is always a major consideration when you’re trading forex. For example, a country could elect a president who introduces new, and starkly different economic policies.
This promise of massive change could weaken or strengthen a country’s currency, and because no one would know for sure what impact these policies will actually have, you’d want to hedge against the currency’s movement to make the most out of the new policies’ effect on the economy, whatever that effect is. This way, you’re able to take advantage of the outcome, either way.
The main reason why forex traders hedge their positions is to reduce risk. If hedging’s done right, it can play a very important role in your trading strategy by protecting you from major losses.