Hedging is a popular trading strategy deployed to protect opened positions in the forex market from adverse events. Traders, as well as forex robots, deploy the short term protection strategy whenever there is concern that news or upcoming events would lead to adverse events that could trigger losses on an open position.
Forex hedging is, therefore, the process of trying to offset the risk of price fluctuations by reducing the impact of unwanted exposure. With forex hedging, traders, as well as, forex expert advisors engage in automated fx trading, opening additional positions to mitigate against losses on an open position.
Traders hedge in the forex market as a way of protecting themselves against exchange rate fluctuations. Hedging makes it possible to mitigate the loss or limit the loss to a known amount. As one of the most important money-making hack in the forex market, if you feel that a currency pair is about to decline in value, one of the most important forex trading secrets is to hedge as a way of reducing short term losses while protecting long term profits.
Types of Forex Hedging Strategies
Simple forex hedging strategy
As the name goes, simple forex hedging entails opening an opposite trade to the one that is already opened. For example, if a trader is long EUR/USD and fears about the potential impact of upcoming news events, he or she can open a short position either manually or with the help of automated trading systems. The direct hedging strategy allows one to accrue profits as price moves downwards while mitigating against losses accrued by the long position.
The net profit in a direct hedge is usually zero as the two open positions cancel each other. However, such a play allows one to keep the original position waiting for a trend to reverse and start moving in the direction of the previously opened position.
The simple forex hedging strategy allows traders, as well as FX Expert Advisors, to generate profits on the new trade even as the first trade makes losses. Failure to hedge a position and opting to close the trade would mean accepting the loss.
However, it is important to note that some brokers don’t offer the provision of direct hedges. Instead, such brokers opt to net off two positions.
Multiple Currencies hedging strategy
Multiple currencies heading strategy is a unique type of forex hedging whereby traders or FX Expert Advisors select two currency pairs that are positively correlated. While hedging, one would take positions in the two currency pairs, but the opposite direction.
GBP/USD and EUR/USD are two examples of currency pairs that are positively correlated. Therefore, whenever one is long, say the GBP/USD pair, he or she would open a short position on the EUR/USD as a way of mitigating any losses that might come into being on the GBPUSD pair.
Consider going long on EUR/USD on the expectation that the EUR will continue strengthening against the dollar. However, upon further analysis of upcoming news events, it becomes clear that the USD is likely to strengthen against the EUR for a short period. A trader would, in this case, open a short position on the GBP/USD to profit on the strength of the USD against the EURO and the British Pound.
However, it is important to note that opening a hedge using more than a currency pair does trigger an increased level of risk. In the example above, opening a short position on the GBP/USD to hedge against the EUR/USD pair would amount to compounding exposure to the dollar while also opening to short exposure to the pound in addition to the long exposure to the euro.
While the net balance is often zero with a direct hedge, that is not the case with multiple currency hedge. In most cases, there is usually a possibility of one position netting more profit than the other position makes in losses.
Forex Option Hedging
Options are some of the best forex trading instruments often used in the forex market for hedging purposes. Unlike other currency hedging tools, options giver traders a chance to reduce exposure while only paying for the cost of holding the option
Assume you are long the EUR/USD at $1.1250. However, upon further analysis, it becomes clear that the EUR is likely to come under immense pressure and likely to decline significantly; In this case, you can hedge your position by opening a Put option at $1.1200 with a one-month expiry.
Should price have fallen below the $1.1200 level at the time of expiry, you would end up with a loss on the long position, but the option would balance the exposure. Conversely, should EUR/USD rise steadily, you could let the option expire and just end up paying the premium.
Hedging strategies are popular trading strategies among experienced traders, as well as, Algorithmic FX Trading systems programmed to undertake such complex traders. The strategy entails opening new positions, in the forex market, as a way of reducing exposure to currency risk.