How forex hedging works?

Forex hedging is a trading strategy that traders use to insure their trades against any big losses they might incur. Hedging in speculative trading is not something new. In fact, traders use hedging all the time, using derivatives. For example, if you owned a stock but you expect the price could fall, then you can hedge this position.

A typical hedge is done when a trader buys a derivative such as a PUT option on the stock. The costs are limited and the PUT option allows the trader to walk away from the trade, if they are wrong. A good example of hedging in the true sense is the VIX or the CBOE volatility index or the fear index.

This index can tell you how bullish or bearish people are on the stock markets. The index uses the CALL and PUT options.

In forex, hedging is a bit different. Not all forex brokers allow hedging, especially market makers. Even with ecn brokers, unless ‘Forex Hedging’ is mentioned in their terms, it implies that the broker doesn’t allow hedging.

Take a look at the different forex broker types here to understand how they work.

Forex hedging is like insurance. You pay a certain amount to ensure that your primary trade does not end up into a losing trade

Example of a real hedge in the financial markets

The term hedging comes from the fact that a trader wants to get an insurance on their trade. This can be done in a number of ways. Traders use what is called derivatives. Derivatives are financial instruments that are derived from the underlying market.

A good example of derivatives instruments is futures, options, forward contracts.

Using these derivative instruments, a trader can insure against potential losses from their main investment.

When a trader uses hedging techniques, they have to part with a bit of their profits. This is the cost or the premium that a trader pays to hedge their trades.

What exactly is forex hedging and why do most traders not allow hedging?

A good way to understand forex hedging is by an example.

A trader has a buy order on a currency pair. Now if they need to insure or hedge their trade, they can at the same time open a sell order on the same pair.

Therefore, forex hedging is where a buy and a sell order is used on the same currency pair at the same time. The net profits from using a forex hedging strategy looks like it results in “zero”. But traders make more money without additional risks,  if the timing of opening the trade is done right. The above is just the most basic and simple example of forex hedging. There are many other complicated methods too.

In forex hedging, stop losses are essential tools to limit the losses and to maximize the profits. If a trader has to open two trades in the opposite direction and set their stop losses correctly, then based on the market price movements even in terms of a reversal, there is profit to be made from both the trades.

However, as noted earlier, forex hedging is a skill that requires a good understanding of price action in order to profit from the opposite trades.

Alternatives to direct forex hedging

Because most forex brokers do not allow direct hedging, traders come up with alternatives that are “acceptable” in theory and in practice as well.

One way to do this is by hedging multiple currency pairs.

In this method, traders hedge against one currency by trading two different currency pairs.

So for example, a trader can open a long position on EURUSD and have a short position on USDCHF. This method doesn’t directly insure either of the trades, at the very least, you are able to hedge the price movements of the USD currency.

In the same note, the downside to multiple currency hedging is that can be exposed to the price movements in both the EUR and the CHF currencies.

Any strong movement from either of these two currencies could pretty much offset your hedging strategy. Traders make use of currency correlation to make such hedges effective.

Another example of forex hedging is using triangular trades. Triangular trades is when you are long on EURUSD, short EURGBP and short on GBPUSD.

While it looks complicated, it is simple. You buy EUR and sell USD. Then you sell EUR and buy GBP. Finally you sell GBP and buy USD. What you end up with this is a trade that nets out to zero. But remember that it is not as easy as it sounds.

Why use forex hedging

Some traders employ hedging strategies in order to minimize their risks.

Although this can be done by using stop losses, hedging can become an additional safety net for traders and can help contain losses on a bigger scale. Traders should make use of hedging only when are fully confident on using these strategies.

It is ideal to start practicing forex hedging on demo trading accounts. This will give you a fair idea on how and when to place the trades. You can also slowly graduate to placing hedged trades in real accounts but with small amounts in order to build up the experience required.

Forex hedging is complicated and you need a lot of practice at the end. Do not blindly follow some EA’s or trading strategies that you find off the internet.

You should also pay attention to your leverage and margin. Leverage and margin, especially when using triangular hedging can eat into your capital. So, unless you have a good practice, it will be difficult in reality.