What Is Hedging in Forex and Is It Really Risk Free?
Hedging in forex is one of the songs that traders sing.
It is like a must-have device in the toolbox.
Especially if you are a veteran trader, it goes without saying forex hedging is no vocabulary to you.
In any case, who doesn’t want to protect their investment against the uncertainties of the forex market?
Who doesn’t want a reduced exposure of their investment against the volatile forex environment?
No one, right?
Even some of the world’s richest worry about losing a dime, sometimes.
It&8217;s with a reason, therefore, that this trading strategy called “hedging” has won the hearts of many traders.
Just by putting on a hedge, you can minimize your losses and even lock in a profit.
That’s right; forex hedging is like a double-edged sword.
It not only helps you make a profit but also helps protect your investment concurrently.
Which is crucial: we all know how the forex market is notorious when it comes to surprises in price movements.
You can have a profit this minute and it’s gone the next second.
You can lose your shirt in the twinkle of an eye.
But forex hedging can help avoid just that!
Hey, not so fast!
There’s a learning curve involved.
You need to do it right!
You need to master the ins and outs of the game.
This may not be your cup of tea if you want to take shortcuts.
Yet, here’s the ultimate thing…
Is forex hedging really risk free?
Is it certain to guarantee profits?
Should you even give it a shot?
That’s a lot of questions, I know, but they are crucial.
In fact, it’s what you are here for.
Or, you wouldn’t be reading this in the first place.
But before we jump right in…
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What Is Hedging in Forex Trading?
In simple words, hedging is buying and selling simultaneously, or within a very short time.
Forex hedging, therefore, occurs when you take double trades in opposite directions – usually at the same time.
By buying and selling currency concurrently, you are helping provide less exposure to your investment, hence, minimizing risk – irrespective of trend changes in the market.
You are shielding your hard-earned-money against adverse price movements, which are the norm during volatile periods.
Here’s an example to illustrate the concept of forex hedging:
Let’s say the EUR/USD is at a very strong resistance level, according to your analysis.
Consequently, you are anticipating that it should not just fall but fall hard.
So, you go short on EUR/USD.
But because you are looking to protect this trade against any trend changes in the market, just in case, you go long on a positively correlated currency pair, say, GBP/USD or NZD/USD – which exhibits a strong support level.
Note that each position is meant to cover each other against unexpected trend changes in the market.
What’s in store for you next?
If the short position becomes a success, it should move a ton of pips than what the long position would give.
Flipping the same coin, if the long position wins, it should yield lots of pips than those seen in the short position.
Therefore, either way, your profit will exceed the loss incurred.
Which means that if you subtracted the loss sustained from the profit realized, you will still be left with a profit.
You’ll have won.
It doesn’t matter which way the market is going to move, but forex hedging helps protect you in both directions.
There’s a reason it’s called hedging: it hedges your investment against the market uncertainties (hedge funds work exactly the same way, too).
Is Hedging in Forex Fit for New Traders?
Maybe you are a new trader.
You’ve already got wind of what hedging can do and can’t wait to put it to use as one of your trading strategies.
Should you really go ahead?
Well, the answer is “no”.
And why is that?
Hedging in forex requires that the trader be well-versed in a number of trading strategies, which is crucial when it comes to making an effective technical and fundamental analysis.
This is not always the case with most newbies, who, in fact, may still be trying to get their feet wet in the trading industry.
I’m sure you can agree with me on this!
Most likely, beginner traders have mastered only one, or two, trading strategies.
Which isn’t sufficient to conduct an effective analysis, be it technical or fundamental.
In addition, beginners may not be aware that the analysis needs to be done based on the long time-frames; not short ones.
And, because timing is key in forex hedging, new traders may not be familiar with this aspect already.
It’s possible they lack the knowhow of when to enter the market and when to exit.
Hedging in forex trading is a no-go zone for beginner traders.
Most of those who’ve risked using the hedging prematurely in their trading careers have had their accounts wiped out.
You don’t want to be a part of it!
Do All Brokers Allow For Hedging in Forex?
Perhaps you have fallen in love with forex hedging already.
But, sadly, you’ve discovered that your broker doesn’t support it.
Well, understand that not all brokers favor hedging, especially those that are based in the US.
Hedging was banned in the US somewhere in 2010, just in case you had no idea.
It goes without saying, hence, that hedging might be a nut to crack for you if your broker is US-based.
Not just the US alone, but it should be prudent if you conducted an online research to find out which brokers are hedging-friendly.
Is Direct Forex Hedging Worth Its Salt?
What is direct hedging?
The answer is right here: keep your cool please.
Direct forex hedging is buying and selling a single currency pair simultaneously.
That’s right; only one currency pair is involved here.
If you buy EUR/USD at 1.1867, then sell it at the same price (1.1867), concurrently, you are said to have put on a direct hedge.
You may have already guessed that you are likely going to break even.
Neither will there be a profit or loss.
So, why should you even do direct hedging if chances are high you will make zero profits?
Well, some may argue that direct hedging is helpful when you are not sure which way the market is going move.
So you prepare yourself for both sides of the coin, just in case.
Then, if you spot a hawkish trend, you close the sell position while letting the buy order run.
If, on the other hand, you discover that the trend is dovish, you close the buy order and let the sell position run.
Finally, look to cover for your losses with the profits made.
But here’s what beats logic:
What if you’re trapped or there’s no volatility on either side of the market?
What if the market is undergoing a pretty long consolidation period?
You’ll be in for trouble, right?
You’ll encounter losses left, right, and center, won’t you?
Are you really going to blame someone for this?
The point is, direct forex trading isn’t really worth its salt.
It is not the best way to put on a hedge.
The perfect way to do hedging is by use of two correlated currencies; not just a single currency pair.
And that brings me to the next sub-topic …
What&8217;s the Best Way to Do Hedging in Forex Trading?
Effective hedging needs to be done right.
Forex hedging needs to follow the rules in order to fetch a profit.
And, yes, there’s a learning curve involved.
You need to know the ropes tied around this particular form of trading strategy.
You need to understand that the hedging strategy doesn’t work on its own, but it works in conjunction with other trading strategies.
Needless to say, you need to master other trading strategies, which would come in handy when it comes to analysis.
Here’s what you need to do:
Identify two currency pairs with a positive correlation; good examples include GBP/USD, EUR/USD, NZD/USD, etc.
Use your analysis to ensure that these currency pairs won’t perform exactly the same way when price moves in either direction.
In other words, ensure that when one currency pair moves strongly in a given direction, the other currency pair will move weakly in the opposite direction.
And, vice versa.
The drill is, your analysis should help identify strong support and resistance levels for the given currency pairs.
Once you’re done, buy and sell the two currency pairs, all together, as per your analysis.
That way, you can be sure to expect a profit.
Simply offset the losses of the losing trade with the profits of the winning trade.
You’ll be left with some profit still.
Point to note:
Hedging produces reduced profits.
Part (or most) of the profit goes into offsetting the loss incurred on the losing trade.
Therefore, if you’re looking to lock in huge profits, be sure to trade larger sizes.
Only do this once you’ve mastered the forex hedging strategy.
By mastering, I mean that you are really confident of the game, you know the ins and outs of every corner, and you can even teach someone else comfortably.
Advantages of Hedging in Forex
1) It Helps Protect Your Investments
Considering the forex market is volatile, and losses are inevitable, hedging comes in just as handy.
It helps mitigate risk so you can experience minimal losses.
For that reason, it’s no strange thing that hedging is viewed as an “insurance policy”, only that you don’t have to pay the fees or premiums.
2) It Is the Perfect Strategy for Busy Investors
Not all investors have the time to keep an eye on their open positions.
And, that’s where hedging comes in.
Through hedging, these investors can surely lock in their profits effectively, without having to monitor their positions constantly.
3) It Is a Powerful Strategy During Economic Downturns
Economic downturns are inevitable.
Consequently, traders are vulnerable to such things as inflation, changes in interest rates, fluctuations in currency exchange rates, etc.
However, while most traders (especially the newbies) will have their accounts wiped out during these unclear periods, professional hedgers have an upper hand and will likely get through these moments of turmoil just fine.
Disadvantages of Hedging in Forex Trading
There are two sides to every coin, and forex hedging is no exception.
Here are the downsides to this trading strategy:
1) It Produces Reduced Profits
Truth be told: when you curb potential losses, you are also curbing potential profits.
Which is why a good percentage of the profit you make in hedging is often not yours.
It goes into offsetting the losses you incurred from the losing trade.
Note that hedging is made up of two trades: a winning trade and a losing trade.
The difference between the two is what you’re going to take home as profit.
2) It Involves Huge Costs and Expenses
Because you need to buy and sell simultaneously, in order to make a profit, your investment needs to cover both sides of the coin.
You need to operate on a big budget.
Let’s say you’ve bought 5 lots of EUR/USD and you’re looking to put on a hedge of a similar size.
Say, 5 lots of GBP/USD.
Now, in order to sell 5 lots GBP/USD, you are going to need a substantial investment.
Moreover, in case you aren’t careful enough to follow the rules, the fortune you’re spending can well eat into your profits.
3) The Long Wait
Unless you’re scalping, which in itself is prone to risks during hedging, you’re going to have to exercise patience when you’re putting on a hedge.
Practically, forex hedging seems to work best in the long term.
Therefore, if patience isn’t your thing, forex hedging might not be for you.
4) Hedging Isn’t a Beginner’s Cup of Tea
For a hedge to be successful, it must incorporate other forex trading strategies.
Clearly, this is a rather steep learning curve for most beginners.
It is especially so considering the analysis that has to be made prior to putting on a hedge.
And, considering that the currency pairs need to be correlated positively, this might take a toll on the new trader.
In addition, because timing is key in forex hedging, beginners may not know when to exactly put on a hedge and when to take it off.
Which is why most newbies are likely to make a loss during hedging.
5) Forex Hedging Can Be a Trap
This usually happens during consolidation periods.
The thing is, hedging in forex works best during periods of volatility, when the market makes substantial moves.
However, when there’s no trend and the market is only consolidating, hedging can be a trap for you.
As a result, there’ll be no way for you to close your positions without incurring losses.
6) Hedging in Forex Can Be Costly
Again, assuming you are not lucky enough to make a profit and you make a loss, you will encounter additional losses by paying the spread.
Did you know repeated losses that result from spreads are a sure way to sabotage your account, even if you are on a big budget?
So, Is Hedging in Forex Trading Risk Free?
Well, it depends.
In my opinion, direct hedging is risky; even if you are lucky to make a profit, it is likely to be a profit by chance.
Making use of correlated instruments can be said to be risk-free to some extent, but only if your analysis is spot on.
Beginners are likely to encounter a loss in forex hedging as compared to their veteran counterparts.
Get it right, please!
I’m not trying to discourage you if you are a newbie.
In any case, we all need to start from somewhere.
The point is, for beginners, please refrain from using hedging during your learning curve.
Ensure that you do learn first, everything, then put to practice what you’ve learnt via a demo account.
This is certain to sharpen your skills.
Once you feel you’re as confident as a bird committing itself to the air, let your live account experience the skills well-nurtured.
And, now, folks, I rest my case.
At this point, I’m sure you can tell easily whether forex hedging is risk-free or comes with a price-tag attached.