How many times have you been stuck in a situation and you try figuring out how you could get out of it? It happens every day, right? Well, that is exactly what hedging is. In a simpler language, hedging means to find a way to get out of a huge loss. A hedge is nothing but insurance that you get on your trade. It is a way to reduce the amount of loss you would incur if something unexpected happens.
Simple Forex Hedging
Some traders might let you place direct hedge trade. When you are permitted to place a trade that buys a currency pair and at the same time you can place a trade to sell the same pair, it is called direct hedging.
When you have both the trades open the net profit will be zero. You can definitely earn a profit without facing additional risks if you time the market just right. Simple forex hedge allows you to trade the opposite direction of your initial trade without having to close that initial trade.
What makes more sense is that you close the initial trade and place a new trade at a better spot. The decision completely depends on the trader.
It is okay if as a trader you want to enter the market at a better price. The advantage that hedge provides is that you can keep your first trade in the market and can try making money with the second trade which will make a profit even if the market moves against your first position. When you think there is a probability of your first trade making profit then you can stop hedging trade or just close it completely.
There is not one method for complex hedging of forex trades. Majority of brokers don’t permit traders to take directly hedged positions in the same account so other approaches are necessary as well.
Multiple Currency Pairs
A forex trader can make a hedge against a specific currency by using two different types of currency pairs. For example, you could go long for example- EUR/USD and short, such as USD/CHF. In this case, it wouldn’t be precise, but you would be hedging your USD exposure. The only issue with hedging this way is you are prone to huge changes in Euro (EUR) and the Swiss(CHF) as well.
In short, if the Euro becomes a strong currency, then there could be a change in EUR/USD that is not counteracted in USD/CHF. This is generally not a trusted way to hedge unless you are building a complex hedge that takes many currency pairs into consideration.
A forex option is a contract to conduct an exchange at a given price in the future. For example, if you place a long trade on EUR/USD at 1.80. To protect that position you place a forex strike option at 1.79.
What this means is if the EUR/USD falls to 1.79 within the time mentioned in your contract, you get paid based on it. How much you get paid depends on various factors such as market conditions, when you buy the option, and the size of the option. If the EUR/USD does not reach that price in the given time then you may lose only the purchase price of the option. The greater the difference in market price and 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 for your trades is to limit risk. Hedging can be a greater part of your trading plan if done properly with carefulness. It should only be used by veteran traders and not the amateurs. It is for people who understand market swings and timing. Playing with hedging without adequate trading knowledge and experience could be a disaster for your account.