What is hedging in Forex Market?
What is hedging in Forex Market?
Hedging on Forex means opening trades in one segment of the market in order to balance out the risks of trades in another. This involves opening opposite positions, which compensate each other in case of any outcome. The main function of hedging is risk insurance, which is carried out with the help of opposite trades.
Naturally, the term originates from the word 'hedge'. Hence the main definition of this term: protecting the trader from the risks associated with the trading. Today, this strategy is widely used by traders around the world. With a decrease in the level of risk, you also get a decrease in profits, but with a competent approach, the probability of large losses is minimized.
On Forex, hedging involves the opening opposite positions for the purpose of risk protection. Such orders are meant to compensate for the losses of other positions with their own profit. This strategy is mostly effective for short-term contracts. For longer contracts, the profit from hedging can be gradually wiped out by the swaps of all the positions.
The hedging strategy is a more advanced risk management option than a stop loss order. After the stop loss is triggered, the corresponding amount of net loss is immediately written off from the balance. There is also always the possibility of an inadequate stop loss triggering due to the low liquidity of the asset or an unexpected sharp market movement with a subsequent return to the original position.
Hedging is a more flexible version of risk management. In this case, an open order is protected by an opposite trade with a similar or other asset that can compensate for the loss of the main position. A hedged trade will not close suddenly or randomly.
Hedging can be either full or partial, where only part of the volume of the main position is covered. The positions can be either in one trading instrument or several. For example, two currency pairs moving in opposite directions.
The most common hedging strategy among novice Forex traders is opening hedging positions in opposite directions for one trading instrument. Traders refer to this type of hedging trade as a lock.
A typical risk insurance strategy using locked positions includes the following steps:
- Opening the main position in the selected currency pair.
- Opening an opposite hedging position in the same trading instrument.
- In case of a loss in the opposite trade, it is compensated by the profit received by the main position and vice versa.
- Losses in the positions can be cancelled out by trend correction or profit taking with the help of secondary opposite trades.
- To reach a small profit, the trader places a stop order in the profit zone, taking into account the loss in the hedged position.
If you learn to use this method by choosing correctly the opposite positions that can secure the main trade, over time you will be able to work with larger lots and get more profits with minimal risk.
The hedging strategy is an advanced technique used by experienced traders. It requires constant monitoring of the current market situation. A trader needs to closely watch the movement of the currency pairs, take into account the price of a point of each of the assets and the swaps. But the biggest challenge is choosing the right moment to open and close opposite contracts.
Article last updated: 2022-10-28