Forex Money Management When and how to use hedging

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How to Use Hedging in FOREX Trading

by David Ingram

Risk management is a key to Forex success.

In the world of investing, hedging refers to making multiple investments with inverse price-action relationships. If one investment weakens, another will strengthen at the same time, limiting the total negative impact that any single investment can have on a portfolio. Although hedging applies most directly to stock trading or investing in general, it is possible to put the concept of hedging into practice when trading currencies in the Forex market. Understanding how to use the concept of hedging in Forex trading can give you an edge in the market and increase your probability of earning consistent returns.

Forex Hedging Basics

Hedging is primarily a risk-management technique, allowing investors to limit the amount of money they can lose in a given timeframe. However, essentially placing bets against each other in the market can limit your profit potential at the same time. The key to making hedging work is to earn greater gains from strengthening assets than you lose from a corresponding hedge. Hedging in Forex has less to do with buying complimentary assets and more to do with placing complimentary trade orders. In many cases, two pending orders can hedge against each other, or partial orders can hedge against losses in a single trade.

Pending Breakout Orders

Pending buy and sell orders can be used to place a hedged bet outside of a consolidation zone, in which trends level off and markets generally move horizontally. Since Forex markets are constantly moving between periods of expansion and contraction, an expansion is guaranteed to follow a contraction eventually. Because of this, traders can place a pending buy order above current resistance and a pending sell below current support. Once the market breaks out of support or resistance, it is likely to continue moving in that direction for at least a short while. Hedging pending orders around a consolidation zone allows you to get in the market at an opportune time, no matter which way the price moves. Once one of the orders is triggered, it is necessary to cancel the other pending order since the trend has changed.

Scaling In or Out

Forex traders have the ability to trade virtually any amount of currency at once, allowing them to break a single order into multiple orders while still putting the same amount of money in the market. If you wished to trade $200,000, for example, you could break that trade into one order to buy $150,000 and another order to buy $50,000. This technique can be used to hedge portions of a single order against itself to capture profits or limit losses. Alternatively, you can close out portions of a single position to capture some profit while keeping the rest of the trade on the table exposed to risk.

Placing Multiple Orders

Although pending orders are preferable, placing concurrent orders in opposite directions can act as a hedge as well. If the two positions are of equal size, one position should make profit at the same rate that another incurs loss, keeping you at a break-even point. The key to profitability with this technique is to close out the losing trade before the winning trade has finished its run, allowing the winner to earn a bit more money than the loser lost and leaving you with a modest profit.

What Is Hedging as It Relates to Forex Trading?

Hedging with forex is a strategy used to protect one’s position in a currency pair from an adverse move. It is typically a form of short-term protection when a trader is concerned about news or an event triggering volatility in currency markets. There are two related strategies when talking about hedging forex pairs in this way. One is to place a hedge by taking the opposite position in the same currency pair, and the second approach is to buy forex options.

Strategy One

A forex trader can create a “hedge” to fully protect an existing position from an undesirable move in the currency pair by holding both a short and a long position simultaneously on the same currency pair. This version of a hedging strategy is referred to as a “perfect hedge” because it eliminates all of the risk (and therefore all of the potential profit) associated with the trade while the hedge is active.

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Key Takeaways

  • Hedging in the forex market is the process of protecting a position in a currency pair from the risk of losses.
  • There are two main strategies for hedging in the forex market.
  • Strategy one is to take a position opposite in the same currency pair—for instance, if the investor holds EUR/USD long, they short the same amount of EUR/USD.
  • The second strategy involves using options, such as buying puts if the investor is holding a long position in a currency.
  • Forex hedging is a type of short-term protection and, when using options, can offer only limited protection.

Although selling a currency pair that you hold long, may sound bizarre because the two opposing positions offset each other, it is more common than you might think. Often this kind of “hedge” arises when a trader is holding a long or short position as a long-term trade and, rather than liquidate it, opens a contrary trade to create the short-term hedge in front of important news or a major event.

Interestingly, forex dealers in the United States do not allow this type of hedging. Instead, firms are required to net out the two positions—by treating the contradictory trade as a “close” order. However, the result of a “netted out” trade and a hedged trade is essentially the same.

Strategy Two

A forex trader can create a “hedge” to partially protect an existing position from an undesirable move in the currency pair using forex options. The strategy is referred to as an “imperfect hedge” because the resulting position usually eliminates only some of the risk (and therefore only some of the potential profit) associated with the trade.

To create an imperfect hedge, a trader who is long a currency pair can buy put option contracts to reduce downside risk, while a trader who is short a currency pair can buy call option contracts to reduce the risk stemming from a move to the upside.

Imperfect Downside Risk Hedges

Put options contracts give the buyer the right, but not the obligation, to sell a currency pair at a specified price (strike price) on, or before, a specific date (expiration date) to the options seller in exchange for the payment of an upfront premium.

For instance, imagine a forex trader is long EUR/USD at 1.2575, anticipating the pair is going to move higher but is also concerned the currency pair may move lower if an upcoming economic announcement turns out to be bearish. The trader could hedge risk by purchasing a put option contract with a strike price somewhere below the current exchange rate, like 1.2550, and an expiration date sometime after the economic announcement.

If the announcement comes and goes, and EUR/USD doesn’t move lower, the trader can hold onto the long EUR/USD trade, potentially making additional profits the higher it goes. Bear in mind, the short-term hedge did cost the premium paid for the put option contract.

If the announcement comes and goes, and EUR/USD starts moving lower, the trader does not need to worry as much about the bearish move because the put limits some of the risk. After the long put is opened, the risk is equal to the distance between the value of the pair at the time of purchase of the options contract and the strike price of the option, or 25 pips in this instance (1.2575 – 1.2550 = 0.0025), plus the premium paid for the options contract. Even if EUR/USD dropped to 1.2450, the maximum loss is 25 pips, plus the premium, because the put can be exercised at the 1.2550 price regardless of what the market price for the pair is at the time.

Imperfect Upside Risk Hedges

Call options contracts give the buyer the right, but not the obligation, to buy a currency pair at a strike price, or before, the expiration date, in exchange for the payment of an upfront premium.

For instance, imagine a forex trader is short GBP/USD at 1.4225, anticipating the pair is going to move lower but is also concerned the currency pair may move higher if the upcoming Parliamentary vote turns out to be bullish. The trader could hedge a portion of risk by buying a call option contract with a strike price somewhere above the current exchange rate, like 1.4275, and an expiration date sometime after the scheduled vote.

Not all forex brokers offer options trading on forex pairs and these contracts are not traded on the exchanges like stock and index options contracts.

If the vote comes and goes, and the GBP/USD doesn’t move higher, the trader can hold onto the short GBP/USD trade, making profits the lower it goes. The costs for the short-term hedge equal the premium paid for the call option contract, which is lost if GBP/USD stays above the strike and call expires.

If the vote comes and goes, and GBP/USD starts moving higher, the trader does not need to worry about the bullish move because, thanks to the call option, the risk is limited to the distance between the value of the pair when the options were bought and the strike price of the option, or 50 pips in this instance (1.4275 – 1.4225 = 0.0050), plus the premium paid for the options contract.

Even if the GBP/USD climbs to 1.4375, the maximum risk is not more than 50 pips, plus the premium, because the call can be exercised to buy the pair at the 1.4275 strike price and then cover the short GBP/USD position, regardless of what the market price for the pair is at the time.

Learn About Using Forex Hedging

Hedging is simply coming up with a way to protect yourself against a big loss. When you buy car insurance, you’re protecting, or hedging, against the chance of having an expensive accident.

In forex, think of a hedge as getting insurance on your trade. Hedging is a way to reduce or cover the amount of loss you would incur if something unexpected happened.

Simple Forex Hedging

Some brokers allow you to place trades that are direct hedges. A direct hedge is when you are allowed to place a trade that buys one currency pair, such as USD/GBP. At the same time, you can also place a trade to sell the same pair.

While the net profit of your two trades is zero while you have both trades open, you can make more money without incurring additional risk if you time the market just right.

The Protection of a Hedge

A simple forex hedge protects you because it allows you to trade the opposite direction of your initial trade without having to close your initial trade. One can argue that it makes more sense to close the initial trade at a loss, and then place a new trade in a better spot. This is one of the types of decisions you’ll make as a trader.

You could certainly close your initial trade, and then re-enter the market at a better price later. The advantage of using the hedge is that you can keep your first trade on the market and make money with a second trade that makes a profit as the market moves against your first position.

Undoing a Hedge

If you suspect that the market is going to reverse and go back in your initial trade’s favor, you can always place a stop loss on the hedging trade, or just close it.

There are many methods for hedging forex trades, and they can get fairly complex. Many brokers do not allow traders to take directly hedged positions in the same account so other approaches are necessary.

Multiple Currency Pairs

A forex trader can make a hedge against a particular currency by using two different currency pairs. For example, you could buy a long position in EUR/USD and a short position in USD/CHF. In this case, it wouldn’t be exact, but you would be hedging your USD exposure. The only issue with hedging this way is you are exposed to fluctuations in the Euro (EUR) and the Swiss (CHF).

This means if the Euro becomes a strong currency against all other currencies, there could be a fluctuation in EUR/USD that is not counteracted by your USD/CHF trade. This is generally not a reliable way to hedge unless you are building a complicated hedge that takes many currency pairs into account.

Forex Options

A forex option is an agreement to conduct an exchange at a specified price in the future. For example, say you buy a long trade position on EUR/USD at 1.30. To protect that position, you would place a forex strike option at 1.29.

This means that if the EUR/USD falls to 1.29 within the time specified for your option, you get paid out on that option. How much you get paid depends on market conditions when you buy the option and the size of the option. If the EUR/USD does not reach that price in the specified time, you lose only the purchase price of the option. The farther away from the market price your option at the time of purchase, the bigger the payout will be if the price is hit within the specified time.

Reasons to Hedge

The main reason that you want to use hedging on your trades is to limit risk. Hedging can be a bigger part of your trading plan if done carefully. It should only be used by experienced traders that understand market swings and timing. Playing with hedging without adequate trading experience could reduce your account balance to zero in no time at all.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.

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