Trading Essentials
What is hedging? How to use the Hedging strategy effectively?
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7 min read
26/06/2023
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what is hedging

The forex market is constantly volatile, with various factors such as economics, politics, and society impacting prices, leading to significant changes. To minimize these risks and protect their positions, traders often utilize a strategy called "hedging." So, what exactly is hedging, and how is this strategy used? Let's find out right below!

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What is hedging in forex?

Hedging in forex is a strategy used to minimize risk in financial trading in general, and specifically in forex trading. When applying hedging, traders create opposing positions. By using derivative financial instruments such as futures contracts or options to protect your current positions from undesired fluctuations in the market.

The fundamental principle of hedging is to place a bet contrary to your initial position. If you are holding a long position on a specific currency pair, you can place a short position on the same currency pair to minimize risk. As the price of the currency pair rises or falls, the profit from one position will be offset by the loss from the opposing position. The goal of hedging is to minimize overall losses in case the market moves contrary to your predictions.

Why should you use a hedging strategy?

Using the hedging strategy in forex trading comes with several important benefits that traders can leverage. Here are the reasons why you should consider using the hedging strategy:

1. Risk reduction: Hedging helps minimize risk in forex trading. By creating opposing positions or using derivative instruments, traders can protect their current positions from undesirable price fluctuations. This helps minimize losses and safeguard invested capital.

2. Profit protection: Hedging helps traders protect their attained profits. If you have a favorable position and want to ensure that you don't lose that profit if the market moves against you, hedging will help you retain the achieved gains.

3. Increased flexibility: Hedging provides flexibility for traders. By creating opposing positions, you can adjust your strategy and modify your positions according to market conditions. This allows you to adapt to market fluctuations and new opportunities that may arise.

However, it is important to note that hedging is not always a good strategy and may not yield benefits in every trading situation. It requires knowledge and skill to apply effectively. Before using hedging, traders should have a solid understanding of the strategy and a clear understanding of the associated risks to make informed decisions.

Types of hedging strategy 

Hedging can help investors limit risks. However, not everyone uses this strategy to its fullest potential. If you find yourself in a similar situation, you can refer to the 3 hedging strategies in forex that we introduce below:

Multiple currencies hedging strategy

hedging forex

Multiple currencies hedging strategy

In this strategy, you open long and short positions on related currency pairs. For example, if you open a long position on EUR/USD, you can open a short position on GBP/USD. This helps protect your positions and balance the risk across related currency pairs.

Let's assume a trader has analyzed carefully the AUD/NZD pair and concluded that it would be advantageous to open a long position on AUD/NZD at 1.05. Everything seems straightforward so far. If the Australian dollar strengthens against the New Zealand dollar, reaching, for example, 1.07, an individual can have a winning trade and earn a favorable payout in the process.

Direct hedging strategy

hedging forex

Direct hedging strategy

The direct hedging strategy involves opening two opposing positions on the same currency pair. This means you buy and sell the same quantity and value of that currency pair. The goal of this strategy is to minimize risk by protecting the profits and gaps between the two positions.

For example, if you open a long position on the EUR/USD currency pair with a size of 0.5 lots, you would also open a short position on the same EUR/USD currency pair with a size of 0.5 lots. When the market fluctuates, the profit from one position will be offset by the loss from the opposing position. However, the objective of this strategy is to protect the position from undesirable price movements and minimize risk.

Forex options hedging strategy

Hedging using options contracts in forex is a popular method to minimize risk in trading. An options contract allows you the right to buy or sell a currency pair at a fixed price in the future.

  • If you have an open Buy order: You can hedge by taking a "selling a call" or "buy put option" position.

  • If you have an open Sell order: You can hedge by taking a "selling put option" or "buying a call" position.

For example, let's say you have a long position on the GBP/USD currency pair and you are concerned about a potential price fluctuation in the near future. To hedge this position, you decide to buy a put option contract with a strike price of 1.3500 within 1 month. 

If the market price of GBP/USD falls below 1.3500 within the expiration of the options contract, you have the right to sell GBP/USD at the price of 1.3500. This helps protect the selling price of your long position and minimize risk in case of a price decrease.

However, if the market price of GBP/USD increases or remains above the strike price, you may decide not to exercise the put option contract and only capitalize on the profits from your long position.

Important note when using hedging strategy

hedging forex

Notes on using hedging strategy

1. Risk associated with the strategy: Although hedging can minimize risk, it does not eliminate it entirely. You need to understand that using a hedging strategy can still result in adjusted profits and potential trading fees. Make sure you evaluate and understand the risks involved before applying the strategy.

2. Trading fees: When using a hedging strategy, you need to consider the trading fees. It is associated with opening and closing hedging positions, including spreads, swaps, and option contract fees (if applicable). You need to have a clear understanding of these costs and their impact on overall profitability.

3. Goals and trading plan: Before using a hedging strategy, identify your trading goals and develop a specific plan. Determine why you want to use hedging, set clear entry and exit points, and establish effective risk management. This will provide you with a strong foundation for managing your trades.

4. Understand and apply correctly: Hedging is a complex tool that requires deep knowledge of the market and related financial instruments. Ensure that you have a clear understanding of how hedging instruments such as option contracts work and how to apply them in specific situations. Choose and apply a hedging strategy that aligns with your abilities and knowledge.

It is important to note that hedging strategies may not always be suitable or profitable in all trading situations. It is recommended to consult with a financial advisor or seek professional guidance to assess the appropriateness of hedging strategies for your individual circumstances.

Conclusion

Therefore, hedging strategy is a risk mitigation strategy that traders should apply to preserve assets and limit losses to the lowest possible level. However, implementing this strategy requires traders to have significant experience and adaptability in the market. Hopefully, through the article above, you have understood what hedging is and gained a clear understanding of hedging strategies in forex.

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