How and Why Use Hedging in Forex

How and Why Use Hedging in Forex

Submitted by adil on Tue, 04/28/2015 - 19:23

Every trader in the forex market is always trying to manage the risk/reward ratio. They are always finding ways to minimize the risk and increase the profits or rewards. For that purpose, there are many forex strategies out there and hedging is one of the best ones.

In many industries, including the forex market, people buy insurances in order to minimize risks. But the insurance fees are too high and to avoid them, the hedging strategy has been developed. Hedging means to buy and sell at the same time or it is the strategy to trade in a short period with two different instruments either in the same market or in the different markets.

Hedging is now very common in forex trading. For this strategy, a trader needs to pick two positively correlated currency pairs. For example, you can choose AUD/USD and ZND/USD or EUR/USD and GBP/USD. Then you need to assume opposite positions on both pairs. In this way you will be able to limit your risks and uncertainty which is what hedging does.

Now that our trades are safe, we need to make some profit out of them. You can involve some technical and fundamental analysis to ensure more rewards. You have taken two opposite positions on two correlated pairs, it is important to note that the two pairs should not move in exactly same directions when making upside or downward movements. In order to explain how you can use the power of analysis for hedging, let us take an example from the recent charts.

If we look at the charts of the beginning of May, we can see that Euro and GBP were supposed to show resistance. But the EUR/USD and GBP/USD were in uptrend for quite a time and a reverse or correction was possible. At this point it seems fine to take short positions on both pairs but it would be too much of a risk if it did not work out even on one pair. So by using technical analysis, we can find the weaker pair and take short position on that one, which enter long position on the other.

Technically, the GBP/USD pair had more pips than EUR/USD in the last one year. This means the Pound was stronger than Euro and that the pair EUR/USD would fall harder. If we look at the economic conditions of Europe and UK, we find that Europe is struggling and its data has not improved while UK has shown constantly improving data. It tells us that Euro has a good chance of falling and it would be bigger than GBP/USD. But we are not sure if it would fall so we enter trade with GBP/USD pair because it has a better chance of not falling. Even if did reverse, its effect would be less than EUR/USD.

Looking at the charts we can see both pairs reaching the peak and falling quickly. As expected, Euro falls with more pips. Taking short on Euro would have left us with $2000 profit. Same method applied if we decide to take a long on GBP/USD and short on EUR/USD. In this case Pound falls with more pips than Euro. Here also we can make $2000 profits. This is the advantage of hedging; no losses.