It is every trader’s dream to limit their downside. One of the popular methods they use to achieve this is hedging, a common practice in financial markets of offsetting potential losses by buying and selling uncorrelated products.
Interestingly, the concept of hedging dates back several centuries, though its principles remain the same today. This practice is prevalent in forex with various strategies, which this article will explore further.
What is hedging?
Hedging refers to the practice of simultaneously buying and selling identical or different pairs as a way to offset risk. So, instead of a trader committing all their allocated capital into one market, they split it up two or three times across various instruments to reduce their downside.
In some cases, the end result once they’ve closed all the positions could be no loss or even profit. For a simple example, let’s imagine a trader wanted to take a long position on USD/JPY. To limit their downside, they may consider a sell trade on the same pair.
If the market went against their buy order and their stop loss was 50 pips, the sell order could at least cancel the first order if they closed both at the same time. It is not every situation where a trader plans a hedge.
They may consider this practice for a trade that’s already against them, although this method does drastically limit the usefulness of hedging in the first place.
Only traders in the United States are not allowed to hedge their positions because of the ban the Commodity Futures Trading Commission placed in 2009.
Most common hedging strategies in forex
There are several different hedging strategies traders employ, all with various levels of complexity. Generally, one should only hedge to decrease the size of a loss. There could be scenarios where one can end up with a profit, though this does not always happen.
We will explore some of the pros and cons of hedging later.
One-pair or direct hedge
This type of strategy involves offsetting positions directly on the same pair. Usually, the net outcome of this hedge should be zero because the loss/profit of the first position will offset or cancel out the profit/loss of the second order.
For example, let’s assume one opened a short position on EUR/USD worth one lot. A direct hedge would be the trader simultaneously executing a long position in the same market also valued at one lot.
If they were only going to have one position with a 40 pip stop loss, the second order should also have the same stop loss. There are usually going to be two possible scenarios with this trade.
If the price went against their buy order, this would leave them exiting the market with a -40 pip loss while keeping the sell order open that now has a running profit of 40 pips.
The opposite is true. If the price went against their sell order, it results in a -40 pip loss with the opposite position in running profits of the same number of pips. The tricky part with hedging overall is the trader has a few options with the current profit.
If they decided to close the latter trade, the net result is zero. Should they instead choose to let it run, they would have to move the stop loss of the running position to their entry or at ‘breakeven.’
This is a risk management action affording the power to not lose above the 40 pips while also providing the possibility of netting more than the running profits.
So, ultimately, this direct hedge could see the trader get more than 40 pips off the order that was left open, or the price could retrace back to their entry, resulting in a 40 pip loss overall.
Multiple currencies hedge
This strategy will use two different pairs strongly correlating with each other. Going back to the previous EUR/USD example, a trader may open a short position on the euro and a long position on GBP/USD.
Their decision to choose the latter could be because it’s a more liquid and fast-moving market than the former. If the euro order was negative, the cable trade should offset this loss to some extent and vice versa.
The main challenge with this hedging technique is, although both of these pairs generally move in the same direction, the correlation may not be positive all the time. So, the trader must be careful not to take a double loss because both markets could go against them within a short period.
Of course, there are variations of these strategies, but most operate on the same principles.
Does hedging work in forex?
When done correctly, hedging can limit a trader’s losses because it widens their exposure. However, not all traders use this strategy for a few reasons. While hedging can typically decrease the downside, conversely, it does also diminish the upside as well.
Therefore, there is a trade-off between reducing losses and reducing profits. For instance, if a trader commits to losing $100 without hedging, this is naturally the maximum they stand to lose.
Let’s assume their reward here is 1:5, equalling $500. With a hedge, they would probably have to split the $100 in two by putting $50 for each market. In most cases, they should at least have a ‘zero trade’ because of the canceling between the two orders.
However, if they alternatively stuck with the original unhedged trade, they could stand to gain $500, which is much better than inhibiting a loss. Therefore, the decision for one to use hedging depends on their priorities between lessening losses or taking them with the hope of hitting a nice winner.
Also, some hedging strategies may be a little too complex to implement; another reason why some traders just stick with one position at a time because it’s simpler.
Someone using hedging is risk-conscious and doesn’t desire to stick with only one trade outcome. However, while the approach does make sense, the biggest disadvantage is it can severely lower the profit potential in the long run.
Thus, anyone employing hedging must strike a balance between lowering their downside while also not capping their upside greatly.