Forex Trading: The Hedging Strategy
Surely, on more than one occasion you have heard of the hedging concept in the context of trading in the financial markets. Hedging is a very common technique to cover open positions limiting the risk in them, and that is why every trader that trades in Forex should know this technique, even if he decides not to use it.
From the outset, it is important to note that the hedging strategy should be considered totally defensive. It is not a strategy that initially seeks to obtain trades with profit, but can simply be very useful for not closing a lossy transaction early when the market reading we do continues to indicate that we are positioned in the right direction.
It is common to have to close a trade with losses when, by monetary management, we can not support a high amount of pips. But closing the trade is still confirming the temporary loss we are suffering in it, when it is possible that sooner or later, the market will again adopt the direction in favor of that trade and losses become profits.
Check out the video for a good explanation on hedging strategies.
How to run a hedging strategy
The hedging technique makes it easier to continue within a losing trade without having to withstand a greater amount of loss as the price moves against us. How do you get that? It is very simple and intuitive: simply take a position opposite to the main trade to cover the maximum risk that we are willing to take.
With an example it is much better understood: if I buy a EUR/USD lot at 1.0845, it is clear that I will get profits whenever the price rises and losses if the price goes down. But it is possible that the price does not immediately take up a bullish position at the time of our purchase, so we could cover the initial losses that can be incurred by selling simultaneously a EUR/USD lot in the same price zone of 1.0845.
That way, no matter how much the price drops in an initial phase,the money I’m losing with my ‘buy” trade equals profits on the my sale position so my result will be neutral. With this hedging strategy, I can wait for the EUR/USD to effectively take the expected direction and then I will be able to close the short hedge operation, and keep only the main purchase trade open, resulting in a NET gain.
In fact, hedging is much more complex than that, since one can “hedge” in currencies or different products with negative correlation, can hedge using derivatives as the options, can open hedging positions with partial amounts, varying the coverage ratio of the position, you can activate the hedging trade at a certain distance from the main one etc…
But it should never be forgotten that hedging implies the payment of a double commission, since two trades are being made, and that must be managed dynamically, because in the end, if we do absolutely nothing with the two opposing positions open, we will not only completely limit the losses, but the profits as well. As a matter of fact, you’ll have lost money due to commissions. Needless to say, hedging is necessary but far more complex than the scope of this article.