Forex Money Management When and how to use hedging

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Forex Money Management: When and how to use hedging

Hedging is a trading tool (or a strategy) widely used by large corporations, funds, but also by retail traders like yourself. How to use forex hedging in the form of securing a trade or forex strategies itself?

We’ll take a closer look at these topics in this article.

What is hedging?

What is hedging: Example

The word hedging does not hide any complexities, as it is simply a paired (opposite) trade. So, if you are in a long position with one tool (long = you have purchased), you eliminate it by the command sell (short = sale).

This may seem like nonsense at first glance, but there are situations in which hedging can be very useful. A typical example is securing an investment. If an open trade is no longer moving in the anticipated direction, making a hedge trade will ensure that your loss does not increase.

What is the significance of hedging?

To sum up, hedging can protect you against risk. For example, if you have a long (buy) position on EUR/USD 1 lot, but the market is not going in the needed direction, you can order sell 1 lot on EUR/USD and thus hedge the position. However, you should be careful, because hedging should already be a part of your forex trading strategy, or you should be more experienced traders, because you may secure the position for a short time, but at some point, the hedging must stop (by releasing one position or ending both).

Moreover, you need to be careful here. With Asian and European brokers, hedging is usually not a problem, but US brokers do not offer to hedge, and they will automatically close your last position with opposite trade. Always make sure your broker offers this option.

Possible realizations of hedging

If you go for a hedge trade, you’ll basically face only 3 possible scenarios of how the trade can go. Either the price will still go against your original trade, or it will give you the opportunity to close the position gradually and end up with a profit. Look at the pictures below.

3 possible outcomes

Hedging instead of stop-loss

Hedging can also be used instead of stop loss. If you reach the stop loss level, instead of closing the position, you enter the opposite position on the same or correlated pair to avoid further losses. If the price goes down, the loss on one of your positions will increase, but your hedging position will also increase profits.

Personally, I would use hedging mainly on shorter time zones (15M, 30M and so on). And when? You enter the position and the market will “flush” you out exactly on the stop loss, then it will return and give you a signal to enter the position from which it “flushed” you out. If you re-enter the same position again and risk the exact same stop loss being attacked, I would rather choose the opposite position instead of stop loss. But if the market turns aggressively, stop loss is the best choice. Hedging is only recommended for more experienced traders. The topic of hedging instead of stop-loss will certainly be dealt with in the following articles, the next question being the best places for leaving hedging. You already know from the pictures above that these may be for example double bottom or a top, but that is not the only option.

Correlated currency pairs

If you look at EUR/USD and GBP/USD or AUD/USD and NZD/USD, you will see that these instruments are positively correlated, i.e. moving in the same direction. By the way, this is useful to know even if you are no longer interested in hedging.

Why? Because if you enter a long (long) position at AUD/USD and at the same time enter NZD/USD, it is basically the same as if you were entering one position twice. When the US dollar falls, both pairs will be affected as well. Your risk is therefore so much higher, and it can disrupt your money management. Beware of correlated couples.

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Demonstration of correlated pairs

Hedging as a trading strategy

If you find correlated pairs, you can also use our help to determine where the potential is higher. For example, if you have a downtrend trading signal and you see close support on one pair, you will use the pair without support for trading and the pair with support for securing (usually in a smaller volume).

The hedging position is partly secured but still offers enough profit. Many forex brokers even support this strategy. Let’s be honest, the forex broker receives more money on fees (because you make two trades) and the customer (us) does a less risky trade, which is beneficial for both.

Other sources of information about hedging and money management:

  • A good video explaining hedging insurance strategy: The Concept of Hedging (2020)
  • Forex Money Management: Embracing losses leads to success
  • Forex Money Management: Trading and psychology
  • Forex Money Management: Martingale – An opportunity or a threat

Author

More about the author J. Pro

Unlike Stephen (the other author) I have been thinking mainly about online business lately. I wasn’t very successfull with dropshipping on Amazon and other ways of making money online, and I’d only earn a few hundreds of dollars in years. But then binary options caught my attention with it’s simplicity. Now I’m glad it did because it really is worth it. More posts by this author

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.

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.

Part 1: Money Management – Hedging

One of many interesting money management strategies, used by many, if not most successful traders, is called Hedging. As the glossary tells us, it is a reinsurance / insurance trade, used to either double your profit, or lower your loss significantly.

What is hedging

Hedging is basically the execution of a second trade in the opposite direction, if your previous trade is in-the-money. This means you have 2 open trades at one time, with the same expiration time. If one of the trades fails, the other is bound to be successful.

Let’s say you buy a CALL option for 30 minutes. After 15 minutes we can see, that the price truly rises, but it seems, that it might go down again and make our trade unsuccessful. If we want to secure our trade, we buy a PUT option right now, this time for 15 minutes (the time remaining until expiration of the first option).

This will ensure that if the price suddenly starts to fall and the first trade does not work out, then at least the the second trade has to and WILL work out and therefore decrease the loss. Do we understand? Let’s make an example.

Examples

Bellow we can find examples of all the situations that can happen.

Double win

At 12:00 we buy a CALL option with expiration time at 12:30 with a strike price 1.2500 for $ 10 and profit of 80 %.

  • At 12:15 we check and find out that our trade is going well. But we can also see that the graph seems to be slowly going back down and therefore we use hedging. We buy a PUT option with expiration time at 12:30, for $ 10 with profit of 80%.
  • The price truly fell, but fortunately not by much. We won both trades. We ended up with $36.

One win

At 12:00 we buy a CALL option with expiration time at 12:30 on the price 1.2500 for $ 10 and profit of 80%.

  • At 12:15 we check and find out that our trade is going well. But we can also see that the graph seems to be going back down and therefore we use hedging. We buy a PUT option with expiration time at 12:30, for $ 10 with profit of 80%.
  • The price however went up. We won one trade, but not the other. We ended up with loss of –$2.

The same situation occurs when:

  • At 12:00 we buy a CALL option with expiration time at 12:30 on the price 1.2500 for $ 10 and profit of 80%.
  • At 12:15 we check and find out that our trade is going well. But we can also see that the graph seems to be going back down and therefore we use hedging. We buy a PUT option with expiration time at 12:30, for $ 10 with profit of 80%.
  • The price has fallen bellow the value of our first option. We won only the second trade. We ended up with loss of –$2.

When to use hedging

This strategy is worth using, if the option is in-the-money in the first moments. If not, we can unfortunately do nothing about it. But if it is, we can secure / insure a profit, or even double it.

If the price spikes extremely immidiately after the first trade was executed and it is almost clear that it (the price) will not return until the expiration date, hedging is probably not the best course of action.

Summary

Hedging cannot be used as a stand-alone strategy. But if you already do have a strategy, hedging is a great thing to use in case of emergency. When we decide to insure with option for $ 10, we can only lose $ 2, but we can win $ 16. That is pretty good, right?

Author

More about the author Step

I’ve wanted to build a business of some kind and earn money since I was in middle school. I wasn’t very successful though until my senior year in highschool, when I finally started to think about doing online business. Nowadays I profitably trade binary options full-time and thus gladly share my experiences with you. More posts by this author

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