Hedging trading strategies minimize risk by trading instruments in opposite directions. For example, holding a long and a short trade at the same time.
They are great protection in bear markets. Traders can protect their assets by opening trades in opposite directions.
You have probably heard that investors will buy put options against their original position. That is one example of a hedge in case of a selloff. There are several hedging strategies to protect your trades in bear markets.
Trading hedging strategies on derivatives can be done while taking a top-down approach. A top-down approach makes it possible to avoid situations that increase exposure from selecting the wrong instrument to hedge your trades. Be sure to check our guide on the best stock trading strategies..
This article will discuss what Forex hedging strategies are. It will explain how to trade them using currencies. Let’s start by discussing what hedging is.
What is Hedging?
Hedging is when you open a trade to offset another trade that you have already opened. Some hedging methods require using a second instrument or asset. By opening this trade you are offsetting the risk. That is why hedging strategies are great in a bear market.
In other words, hedging strategies help to limit losses without using a stop-loss strategy.
In a typical trading strategy, stop-losses are used to limit losses if the trade doesn’t go as planned. This is one reason hedging strategies are useful. It allows a trader to keep their current position without closing the the trade.
You simply cannot be successful in the long run if you don’t limit your downside risk.
How to use Hedging Trading Strategies.
Hedging strategies work similarly to a stop-loss. They both limit losses. But, hedging allows you to also make money on the hedged trade if done correctly.
There is one big mistake retail traders make. They believe a Forex hedging strategy means to place an equal and opposite trade to the one that you already have opened. In other words, if you opened 1 lot long of EUR/USD, you would also open 1 lot short EUR/USD to offset the first trade. However, that’s not how hedging works.
A successful requires holding long and short trades at the same time on the same pair. It is typically used to pause the profit or loss during a reversal. If the market is going up and you are short, you might buy to temporarily hold the position until the market turns back in your favor.
That’s just one angle to understand Forex hedging.
Some traders fall into the trap of incorrect thinking. They believe that since they are fully hedged, there is no risk. They will often just let the trade run for weeks and months. That is incorrect. Traders must consider other factors like the carry cost. Otherwise, their Forex hedging strategy can suddenly lead to bigger losses.
See some advantages of using hedging in Forex trading below.
Why Do You Want to Hedge in Forex Trading?
There are a number of benefits of hedging in Forex trading:
First, hedging will allow traders to survive bearish market periods or economic recessions. It can greatly reduce a trader’s exposure to risk. A successfully implemented hedging strategy will provide protection against negative market moves. This includes, but is not limited to inflation, fluctuations in commodity prices and currency exchange rates, as well as, changes in central bank interest rate policies.
Second, derivatives can be used to implement hedging strategies. Options and Futures can be used in short-term strategies, to reduce the risk for long-term traders.
Third, some hedging tools can be used to effectively lock gains for traders. In this case, the benefits of hedging often materialize in long-term gains.
Finally, hedging strategies can save time. They allow long-term traders to leave their portfolios alone despite daily volatility in financial markets.
The following section details some disadvantages of using hedging strategies.
What are the risks?
Although hedging is meant to minimize overall risk for a trader, it can be risky.
Along with its benefits, Forex hedging also has certain disadvantages.
First of all, the successful implementation of any hedging strategy requires solid experience in Forex trading. Novice traders may find hedging a bit overwhelming and if the strategy is not carried out properly it may lead to more losses rather than help reduce them. Therefore, it is recommended that beginners practice hedging on a demo account first, and when they feel confident enough – start using such a strategy on a live trading account.
Second, risk and reward parameters of hedging are usually proportional, or when a trader reduces risk exposure, he/she also reduces profit potential. A proper hedging strategy should protect a trader from a big loss in the short term and will not excessively reduce his/her long-term profit potential.
Third, we should also note that a Forex hedging strategy is associated with costs that may eat up gains – hedging with Forex Options is one such example.
Fourth, hedging works best for swing and position traders, while it may be a hard strategy to follow for traders with a shorter time horizons (day traders, for example).
Fifth, hedging usually offers little in terms of benefits when currency markets move within a trading range.
Finally, traders need to bear in mind that hedging also requires a larger amount of capital. They need to make sure their account balance is sufficient to place a direct hedge or to cover the premium if they use Forex Options. Retail Forex traders with rather limited trading account balances may consider using a tighter Stop Loss on their positions in order to allow their balance to increase.
Get this Strategy in a Free EBOOK!Download this Prop Trading STRATEGY and get it delivered to your email inbox!
- Get a PDF Download
- 6 simple rules of the strategy
- More info on our prop firm!
Let’s now get into the nuts and bolts of what types of hedging strategies you can use.
Types of Hedging Strategies
If you want to use a Forex hedging strategy with a US Forex broker, it’s not possible. Hedging was banned in 2009 by CFTC. However, if you want to get around the FIFO rule you can use multiple currencies to hedge your transactions.
Now, we’re going to show you one forex hedging strategy that uses multiple currencies to hedge. You might need to read this a few times you haven’t read this before.
Just remember that when you buy a particular currency you’re always buying one currency and selling the other one. Conversely, when you’re selling you’re always selling the first currency and buying the other. So, that’s one of the checks you need to make.
Let’s say as an example of hedging strategies that you buy the USD/JPY. If you want to use hedging strategies you then have to also buy EUR/USD. In this case, you’re effectively buying EUR/JPY because the USD parts cancel each other.
Now, in order to hedge your trade, you need to sell EUR/JPY
Those three transactions together form a hedge.
Why do they form a hedge?
Because on the EUR you have both a buy and a sell, on the USD currency you also have a buy and a sell, and on the YEN you also have a buy and sell.
This is a perfect hedge and a perfect example of hedging strategies that use multiple currencies.
Note* When using these hedging strategies, the big trick is to make sure that you buy and sell transactions that cancel each other.
In the picture below you can see a number of hedging alternatives that you can play around.
Let’s now look at other types of hedging strategies.
See below:
Gold Hedging Strategies
Gold is a perfect hedge if you want to protect yourself against higher inflation. Gold prices tend to benefit when inflation runs out of control. But, Gold is also a hedge against a weaker US dollar. In other words, there is an inverse correlation between gold prices and the US dollar.
If Gold prices go up, the US dollar goes down and vice-versa.
Historically, Gold has always been perceived as a form of money, which is the reason why it’s a good hedge against a dollar collapse or against hyperinflation.
Hedging Strategies for Options
Options hedging is another type of hedging strategy that helps protect your trading portfolio, especially the equity portfolio. You can apply this hedging strategy by selling put options and buying call options and vice-versa.
Options are also one of the cheapest ways to hedge your portfolio.
Forex Hedging Strategy Using Two Currency Pairs
There are many financial hedging strategies you can employ as a Forex trader. Understanding the price relationship between different currency pairs can help to reduce risk and refine your hedging strategies.
By using two different currency pairs that have either a positive correlation or negative relationship you can establish a hedge position.
For example, EUR/USD has an 83% negative correlation with USD/JPY. In this case, you can go long EUR/USD and short USD/JPY to hedge your USD exposure. The only drawback with these types of hedging strategies is that you’re exposed to the exchange rate fluctuations in the EUR and JPY.
In other words, if the EUR strengthens against all other currencies, then we can have a situation where the move in EUR/USD is not counteracted in USD/JPY.
See figure below:
Oil Hedging Strategies
Some currencies are more exposed to the influence of the oil price. The more noteworthy example is the Canadian dollar. Usually, there is a positive correlation between the oil price and the Canadian dollar exchange rate.
When the oil price strengthens, the USD/CAD exchange rate will weaken.
In this case, you can use the oil hedging strategy to hedge your exposure on the USD/CAD trade. You can go long USD/CAD and open a short hedging position in Oil.
Hedging Strategy FAQ
Is forex hedging profitable?
Hedging is a low-risk strategy that doesn’t seek to make a profit but it looks to reduce the volatility of an investment or the amount of risk associated with the changes in the price. At the same time, the hedging strategy can be considered profitable if the trader succeeds in limiting the potential risk of an investment.
What are the different types of hedging strategies?
The 3 most popular hedging strategies to reduce market risk are the modern portfolio theory, options strategies and market volatility. The portfolio construction helps investors reduce volatility by implementing diversification. Options help investors limit losses and by using the volatility index the VIX, investors can track periods of a spike in volatility.
What is the difference between hedging and speculation?
Hedging and speculation are quite different. Hedging is a form of reducing the risk of investment while speculation seeks to amplify returns from the changes in the price. These two types of investment strategies are useful but it all comes down to what you’re trying to achieve.
What is the best hedging strategy?
The option trading strategy is the best hedging strategy. In stock trading, if you buy put option with a much longer time to expiry and a low strike price provides the best form of protection against any adverse price movement in the stock market.
What is a perfect hedge?
A perfect hedge is an investment strategy that eliminates 100% of the risk associated with an existing position. In practice, the perfect hedge can be very rarely implemented because one would need to have two investments that have 100% inverse correlation.
Final Words – Hedging Strategies
Retail traders hedge their trades mainly for psychological reasons and not because it’s a good trading strategy. By being able to use financial hedging strategies we get the feeling that we’re not wrong about our trades, we’re just holding for a while and then we’ll take the hedge off when things are going in the direction that we know they’re going to go.
Swing Trading ReportGet Our Free Swing Trading Strategy
Get Our Free Swing Trading Report Today!
- Entry Points
- Exit Points
- Risk Managament
- Time Saving Tips
No matter which types of hedging strategies you use, you need to understand that there are no free lunches in trading. Hedging is like buying insurance against losses!
The Forex hedging strategy is a great way to minimize your exposure to risk. It not only helps you to protect against possible losses but also it can help you to make a profit. Be sure to check out our article on
Thank you for reading!
If this is your first time on our website, our team at Trading Strategy Guides welcomes you. Make sure you hit the subscribe button, so you get your Free Trading Strategy every week sent right to your inbox.
Feel free to leave any comments below, we do read them all and will respond.
Please Share this Trading Strategy Below and keep it for your own personal use! Thanks Traders!
