In this article, I’m going to be answering the questions: what is hedging in forex and how to use it?
Hedging is an instrument used to reduce risk. Practically, hedging is the action of taking an opposing trade position on security, currency, and or asset.
These risks are fundamentally associated with selling and buying an asset.
Technically, market data and price action are sometimes dependent on several other factors that may not be at our fingertips.
But with the practice of hedging as a risk reduction strategy, we could reduce our chances of being swept by market fluctuations.
How hedging works – What is Hedging in Forex?
I use hedging alongside other strategies to increase my chances of profitability.
Increasing profitability is the goal.
Although, It is important to note that hedging is more of a risk-mitigating tool/strategy than a profit maximization strategy.
An example that would serve better as a risk-mitigating strategy would be a situation where a currency pair is bullish.
Normally, a pullback would result in a temporary loss.
But in this situation, with the use of hedging strategies, you would still be able to mop up some pips.
There are two things to do when setting up a hedge:
- The initial trade and;
- The backup trades
The Initial trade
The Initial trade fundamentally is the trade that puts you into the market.
The initial trade is simply the first position you take while entering into the market whether it be a buy or a sell order is what your initial trade is.
With your take profit and stop loss in place, the price action should start moving in favour or against the favour of your trades
The order book above shows an entry into the Euro Dollar market (EURUSD).
Indicating a buy order, I am placing a trade that puts me in at 1.12191 with the intent of securing a roughly 170 pip profit.
Noticed I placed my stop loss at 1.12159 as this is a strategy, I use to reduce my losses while putting my take profit at 1.30000.
The market generally is in an uptrend right now which is why I’m very optimistic about placing my take profit a bit high.
Analysis gathered on the initial trade mostly influences your hedge or backup trade.
The Backup trade
The counter trade or the backup trade is the pillar of the hedging strategy.
Place the backup trade right above the stop loss of your initial trade.
This is done to put you back into the market a few pips if and after you’ve been thrown out by your stop loss.
It immediately inserts you into a new position depending on the position of your initial trade.
Pay attention to the order book above.
This is a simulated trade setup to illustrate a hedging strategy.
Recall in the first/ Initial trade I entered the market at 1.12191 EURUSD, putting my stop loss at 1.12159 and my take profit at 1.30000.
With that in mind, I placed a simultaneous trade putting me into the market at 1.12134 right beneath my stop loss.
In this second position, I am a long EURUSD.
The reason I’m going long EURUSD is that the market was currently consolidating so I predicted the market to drop a little before continuing on the uptrend.
Luckily for me, I didn’t need the hedge trade as the initial trade made a profit and didn’t hit the stop loss to trigger the second trade.
The Importance of a Hedged Trade
The importance of a simple hedge trade is that it protects you because it allows you to trade in the opposite direction of your initial trade without having to close your initial trade.
One can argue that it makes more sense to close the initial trade at a loss, and then place a new trade in a better spot.
This example is one of the types of decisions you’ll make as a trader.
The advantage of using the hedge is that you can keep your first trade on the market and make money with a second trade that makes a profit as the market moves against your first position
Summary – What is Hedging In Forex
The main reason that you want to use hedging on your trades is to limit risk. Hedging can be a bigger part of your trading plan if done carefully.
Although it is imperative to understand how to correctly set up trades.
It takes keen attention to detail coupled with practice to fully understand how to manipulate market data to your advantage.
Playing with hedging without adequate trading experience could reduce your account balance to zero in no time at all.