Trading forex comes with its own set of risks and traders are always looking for new ways to offset risk and increase profits. One of the ways many traders do this is through hedging.
Hedging is simply the offsetting of risk while retaining the ability to still earn a profit. There are several different hedging strategies that vary in complexity. However, it’s safe to say that if you’re a beginner trader then you should avoid hedging until you gain more experience and a better understanding of it.
One of the things to remember when you’re considering hedging is that while it can limit your risk, it cannot completely get rid of it. Another is that hedging can also limit the profits that you earn on a position so it’s important to think about thoroughly before using it.
Simple Hedging Strategy
A simple forex hedging strategy would involve direct hedging. Some forex brokers allow direct hedging while others do not. You would implement direct hedging by opening a position which buys a currency pair while simultaneously opening a position that sells that same pair.
While you have both pairs open at the same time, the profit you’d receive is zero however if your timing is right, you can make a profit without any added risk by closing one of those positions.
You benefit from this because it allows you to open two positions for two different directions and choose which one to close and keep open, therefore reducing your risk of a loss and increasing the chance of a profit.
Some would say that after observing the direction of one market, to just close your current positions and open a better one, however, this is entirely up to you. That was a more straightforward and simple way of hedging but there are other hedging strategies.
Complex Hedging Strategy
There are a number of more complex hedging strategies but we’re going to briefly talk about the use of multiple currency pairs.
You can hedge against a currency by making use of two different currency pairs. Take for example you go short with EUR/JPY and go long with JPY/USD. What you would be doing in this situation is hedging the JPY exposure. However, the problem in this situation is that you would be vulnerable to fluctuations in the US Dollar and Euro.
Therefore if say the US Dollar becomes strong against all the other currencies, there would be a fluctuation in the JPY/USD that cannot be counteracted by the EUR/JPY pair. This strategy itself is not easy to implement with great success unless of course, you’ve got the knowledge and experience to create a web of currency pairs that would result in you earning a profit.
At the end of the day, hedging does indeed mitigate risk but it’s not something for just any trader. It requires knowledge, experience and in many cases impeccable timing. But when it’s done right, it is worth it.