Hedging Strategies in Forex Trading

Hedging Strategies in Forex Trading

Table of Contents

Introduction

Trading in the financial market has been popular for decades, but it has a lot of uncertainties which makes it difficult for traders to survive long. To gain peace of mind in financial trading, there are various strategies and analyses designed to protect traders from the risks of the market. The strategies and analysis help them plan and take a brief note of the market movements. 

Hedging strategies is one of the most used and significant forex trade strategies. Traders prefer the financial strategy to avoid the market risks and protect their investments. It is like when a trader notices that the market will go low, they will quickly use hedging strategies and a couple for others to have a stable forex trade. 

Thus, the strategies make traders and investors more confident of their investments with market protection and risk management. In the article, we’ll discuss various aspects of hedging strategies and their use to have an understanding of the strategy. 

What is Hedging?

Hedging is a financial strategy that has lots of advantages for the traders and investors of the market. As a strategy, it protects the trader from exposure to high risks and makes a profit from the trade. However, traders should know that it won’t minimise the risk completely; traders may have to face some loss. 

It is a useful practice that every trader should use; protecting the investments and ensuring some profits will make traders more confident of the trade and skills polished. The strategy is most useful for the beginners of the trade as they have less market knowledge, and it would enhance their trade over time. 

The risk management strategy offsets the losses of the investment; the trader takes an opposite position of the traded security to minimise their risks and ensure profits. Involving the derivative products, hedging has a lot of options for the traders. However, with the potential reduction of risk, there is a reduction in profits as well. 

Let’s get into some more details of hedging and how it can be used for profitable investments and minimise the risks of forex market trading.

In hedging, traders invest in two different investments with adverse correlations to one another. It is like insurance that we get for protecting from the unknown incidents of life. Therefore, hedging protects traders from the volatility of the market. All levels of traders use hedging strategies for minimising the risks associated with the trade.   

Hedging prevents the investments from the adverse impacts of the market, and it could be used in financial markets such as: 

  • Forex market 
  • Interest rate 
  • Commodities market 
  • Weather 
  • Securities market 
  • Stock market 

Types of Hedging Strategies 

Hedging strategies in forex trading or other markets could be used in various types. Investors have the hedging strategies in forex trading classified into the following: 

  • Forward Contract: A contract that is customised and is between two parties of the financial markets. They buy and sell the currencies for a specific price and at a future date specified in advance by the trade parties. Traders use the forward contract for hedging and speculation; however, the non-standardised aspect of forward contracts makes it more convenient for hedging. The contract is not centralised and used for over-the-counter trading. These are not traded on exchanges, and it is settled at the end of the contract with cash or delivery basis. 
  • Futures Contract: A contract similar to the forward contract, where traders bought and sold currencies for a specified price and specified date in future but still different. It is a binding contract where traders have to pay on the specified date and could not extend it for the future. The currencies are traded on a recognised exchange. Traders can use the futures contracts for hedging in the forex trade to minimise the risks. 
  • Money Markets: Money markets are different from the above two trading contracts; in this, the trade is short term. Traders buy and sell, lend and borrow the currencies with less than a year’s maturity time. With various currencies, traders can invest and avoid the market risks with some profits. 

How to do Hedging in Forex?

Traders of the forex market have to be aware of hedging strategies in forex trading to protect the trade from risks of uncertain markets. The forex market is highly liquid, and with ample opportunities for the traders, it also has high market risks. So, traders can use hedging strategies to avoid the unnecessary risks of the forex market. 

The hedging strategy works in the same way as the stop-loss order. Traders have to be careful while choosing the alternative trade of the investment to support the first one. However, forex traders have a misconception about the use of hedging, where they believe that investing in the same currency is equal and opposite of the investment with the same trade position. 

To better understand this, say, for instance, a trader buys the currency pair for 1 lot, and he sells the same currency pair of the same size that is 1 lot for offsetting the first one. This is a totally wrong procedure to use hedging in forex. 

It requires traders to hold the forex currency pair by buying and selling the same currency pair. In the frex trade, the traders use the hedging strategy to pause the profits and loss during the pullback situation. When the market is moving upwards, and traders have a short position, traders buy to hold a temporary position in the market. Traders wait for the market to reverse and be in their favor to take advantage of the opportunity. 

Traders use hedging strategies to limit their losses and have a potential profit from the trade. 

Forex traders can use the strategies by opening a market position or even multiple positions. Traders invest in the market with other currency or financial products that move in opposite directions. With this, traders can close their initial position and enter other market positions when they want. Traders use hedging to keep their first trade and earn from the second position held in the market. 

What is a Forex Hedging Strategy?

Several forex traders use a forex hedging strategy to reduce the market volatility and the risk associated with the trade. Traders invest in other currency pairs or financial products using the strategy. For example, if a trader invests in the USD for a long position and then invests in EUR as a hedge. This will reduce the chances of loss when the value of the dollar falls in the market. Traders will have profit from the Euro. Thus, minimising the risk and loss of the trader with another investment. 

Before learning about the hedging strategies in forex trading, let’s understand the concepts relating to the forex trade. It includes three key concepts that impact the forex hedging strategies, risk, correlation and diversification. 

Risks 

Risk in the trade is the profit and loss that traders can have from the trades. The hedging strategies of the forex market reduce the risk associated with it. Traders are able to earn profits from the short term strategies for a long term trade position. Hedging strategies protect forex traders from the risks of the market and help them gain potential profits from the underlying investment. 

Traders use the hedging strategies along with the tools of the trade like stop-loss order and take profits etc. It is used when traders feel the market risks and use hedging for protection. Once the market shows reversal, traders remove the hedging strategies. Thus, a short term strategy. 

Correlation

A statistical term, correlation, is the degree to which the variables move in relation to one another. Traders of the forex market study the two currency pairs, and if they move in the same direction, they use it for having favorable trade. The traders measure the correlation of the currency pairs using the scale -1 and +1. 

Here, -1 means the two currency pairs are moving in opposite directions, and +1 means they are in coordination and move in the same direction. There is one more point, zero, which indicates that the currency pairs are independent of each other and do not have any impact on each other’s movement of direction. 

Diversification

Diversification, as a term, means to diversify the trade in other sectors of finance for potential gains. Traders of the forex market use diversification to increase their trade in various currency pairs or financial instruments to reduce the risk of loss. 

In the forex trade risk, the traders are of the opinion that the investment may turn out opposite, and they may face loss. So, to minimise the impact of the trade risk, traders invest in other currency pairs for a secure trade and good profits. To protect their accounts from wiping away. 

Traders can diversify their risk by investing in financial products which are correlated with the investment or others which have no relation. The products available for diversification of the forex trade are: 

  • Currency pairs 
  • Contract of difference (CFDs) 
  • Options contracts 
  • Forward and futures contracts

Hedging Strategies for Forex Traders

How to use hedging in forex? Has been answered, the next thing to focus upon is the hedging strategies for forex traders. In the paragraph, several hedging strategies are mentioned that forex traders can use to enhance their trade with protection from risk. 

The two most common forex hedging strategies are: 

  • Direct hedging 
  • Correlation hedging 

Forex Direct Hedging Strategy

The direct hedging strategy of the forex market is used when a trader already holds a market position. The trader has a position on the currency pair opens on the same currency pair with the opposite position. 

The strategy could be better understood with an example; a trader holds a long term position with the USD/EUR currency pair, so in order to minimise the risk trader will open a short term market position with the same currency pair having the same lot size. 

Using this strategy is useful for forex market traders as they have a net profit or loss of zero; the cost of each trade opening position impacts the profit, so traders should accordingly invest and use the forex direct hedging strategy. Traders close their initial position with the acceptance of loss; there are traders who use a direct hedge to make profits, investing in the second trade for protection from risks and loss. 

Forex Correlation Hedging Strategy

Correlation hedging strategy is common among traders, where they seek some relation between the two currency pairs for investment. In the hedging strategy, traders use two currency pairs and study their market trends, and according to the need, they choose a positive correlation currency pair or negative correlation currency pair. 

Once they have selected the currency pairs that they take opposite positions in the market for the same. For example, if a trader invests in USD/EUR and GBP/USD, two currency pairs with a positive correlation. The trader has to check for the geological, political and social factors impacting the trade of countries for a better investment. 

A trader holds a long position in USD/EUR; then, the trader would use the GBP/USD pair for a short term position as a hedging strategy. 

However, traders should be aware of the fact that their exposure to the market has increased with the correlation due to two currency pairs. 

How to get Hedging Strategies in Forex Trading?

Traders have to follow the steps given below to use the hedging strategies in forex trading: 

  1. Traders have to first open a trading account with trusted and regulated brokers such as PrimeFin. They can open their trading account login and execute their trader using the services provided by the broker. 
  2. Next, traders find the currency pair they want to invest in. The brokers have several currency pairs to offer. 
  3. The third step is to choose the position they want to open with. A long or short position and the size of the lot. It should be in balance with the existing market position, if any. 
  4. The last step is to place the trade and monitor the market trading for opportunities and further investments. 

Conclusion

Trading with the hedging strategies in the forex market is quite helpful. Traders can hold short market positions with the alternative investments; they can minimise the risk, protect their investments and have potential profits. Thus, a beneficial trade strategy that enhances the investments and profits with skill development. A suitable strategy for the beginners of the forex market trade. 

However, traders should first study the market, positions held, and the currency pairs to have potential gains. 

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