What is Hedging?
Hedging is a way of attempting to protect yourself against a negative event that can move the market against your initial position. You can think about hedging as a form of insurance in case something goes wrong with your trade. The concept of hedging is simple.
We can distinguish two hedging methods :
- Direct Hedging is when you buy a currency pair and then at the same time you sell the same pair. In this case, your trade portfolio will remain pretty much balanced because any potential losses will be offset by the trade taken in the opposite direction. So, as long as you keep your hedging position on your risk exposure will be kept almost at zero.
- Indirect Hedging is when you buy/sell a correlated currency pair to hedge your current market exposure. A lot of Forex brokers don’t allow direct hedging in which case the indirect hedging method comes very handy. Indirect hedging is also referred to as Pair Hedging.
A more convenient approach to hedging is to buy and sell a currency pair that is more correlated to your current trade. For example, EUR/USD has a negative correlation of about 91% to USD/CHF in which case if you have long exposure on EUR/USD and want to hedge your risk you would take a short position on USD/CHF.
You have to keep in mind that indirect hedging will never match your portfolio perfectly because if you hedge your long EUR/USD with a short USD/CHF position you are basically only hedging your USD exposure.
In other words, you’re still exposed to the EUR and CHF fluctuations, in which case if only the EUR currency group becomes weaker, it can be the case the move in EUR/USD is not replicated by USD/CHF. So, in order for indirect hedging to have higher chances of success, it’s best to stick to only high correlated currency pairs, above +(-)80%.
Hedging Tips and Tricks
- In order to properly hedge your risk exposure, you need to have a good timing. In other words, your entry level is quite important so you need to make the best out of your price action reading skills.
- One of the most important things to keep in mind is that hedging requires a lot of flexibility. In this regard, the hedging guidelines outlined through this article are not set in stone. As you grow as a trader and gain more experience you can become better at this type of trading activity.
- Hedging works best in range-bound markets.
- In a direct hedge, if one of the trades has reached a level from where it’s likely to reverse, you can close the hedge in profit and wait for the market to turn in the direction of your initial trade
Range Hedging Strategy
The hedging strategy that yields the best performance can be found in a range bound market; this is one of the reasons why we recommend if you’re still a beginner to only deploy hedging in a ranging market and only using direct hedging.
Now, the first step is to identify the price range by simply drawing horizontal support and resistance lines.
Secondly, let’s assume a hypothetical trade situation where we buy EUR/USD at support level 1.1700 and at the same time we hedge our position by taking a short at 1.17001. This way we ensure we mitigate our risk exposure.
Once we’re in the trade the market moves upwards and retests the resistance level. We’re now holding a long position which shows us +120 pips profit and a short position that shows us roughly the same amount of pips but on the negative side. You close the profitable position and hold the short position open in anticipation of the market moving lower from resistance level.
Your price action reading skills prove you right, and the market reacts lower from the resistance level, giving you the chance to close your short trade at breakeven.
Now, you could have repeated the hedging process once we hit the resistance level, but in order to keep the things simple, this hedging strategy is good enough to mitigate your risk exposure and at the same time profit from your trades.
The sole purpose of hedging is to limit losses, but at the same time, keep the potential to make profits. There is also a cost associated with hedging which can limit your potential profits. So, it’s important to only mitigate risk when the market has moved against your initial position but has not yet invalidated the technical reasons behind your trade.
It’s recommended that you only use this particular hedging strategy after you have a full understanding of the risk involved, and once you have gained enough experience to master the more basic hedging concepts.