How to Hedge in the Forex Market?
Hedging is one of the oldest strategies in trading not just the forex market but other financial markets as well. Questioning its authenticity and neglecting its value in your trading approach can leave loopholes that result in loss over time. Despite the fact that you don’t really need to hedge every trade you take, understanding the technique gives you an additional risk management tool you can easily access whenever needed.
What is a Hedge?
Hedging, in its simplest form, can be thought of as an insurance. When forex traders decide to hedge, they are trying to protect themselves against the possibility of their initial trade turning against them. While often considered an advanced trading strategy, the essence of a hedge is fairly simple to understand. Still, it takes considerable experience and rigorous training for the practical application of the technique.
To better understand how a hedge works, let’s take it down a notch with a commonplace example. When you or a relative takes out insurance to reduce the financial impact of losing your source of income, you are actually participating in a hedge without even knowing it. Although the textbook definition of a hedge is a position taken out to minimize capital risk of another investment, insurance is perhaps the best real-world example of a hedge.
Applying it to Forex
When a forex trader enters into a position with the purpose of protecting a current or future position from undesired movements in exchange rates, this can be treated as a hedge. By using a forex hedge correctly, a trader that opens a long position effectively protects themselves from downside risk and vice versa.
Hedging in the forex market can be done either through spot contracts or binary options. Spot contracts are the most popular way traders invest in the forex market. As the name implies, it involves trading the spot exchange rate of currencies. Currency options, on the other hand, work better with forex hedges since they have a longer expiry date. Forex options basically give the contract holder the right to buy or sell the currency pair at a predetermined exchange rate in the future.
Checklist for a Forex Hedge Position
A forex hedge strategy is created in four parts, namely the analysis of a trader’s capital risk exposure, risk tolerance, determination of the appropriate hedge strategy, and evaluation and continuous monitoring of the strategy’s results.
In the first part, traders must decide what kind of risk they are taking from the current or anticipated position. The trader must then determine what implications lie if they fail to hedge the position and whether the risk level is high or low in the current state of the forex market.
For the second part, you must identify your personal risk threshold. How much dollar amount are you prepared to lose per trade? In trading, you have to acknowledge the fact that there is no trade that will have zero risk. Being unable to accept this fact can lead to large losses over time.
The final two parts are concerned with figuring out the actual parameters that will be used to hedge trades. If you are using currency options, determine which strategy best complements the underlying asset. Implementing and monitoring your strategy through detailed records or journals ensures that your hedged trades are working correctly.
The Downside of a Hedged Trade
While the technique does minimize capital risk, there are downsides to employing hedged trades. Keep in mind that the goal of a hedged trade is to cap losses if your current or anticipated trade ends up in the wrong side of price action. It is not a tool that makes money hence the cost of the hedge is something you’ll have to pay out of pocket.
Although hedges are synonymous to insurances, it is worth emphasizing that insurance is far more accurate than a hedge. With an insurance backing your investment, you are absolutely compensated for the loss.
Hedges should be treated as a tool you can use during certain forex market environments. It’s not something you need to practice each trade, but rather something that can minimize potential loss in especially volatile situations. Practice the technique in a demo account first before moving onto a live account.