If you are a trader, you have probably heard the concept of forex hedging at least once. So what is Hedging? In today’s foreign exchange market, hedging is considered a type of risk protection contract. It has attracted the attention of many traders. Let’s explore this method in detail with Forex Trading in the article below.
Overview of the Hedging Method in Forex
Hedging is a price protection measure that helps reduce investment risk. However, to use Hedging effectively and avoid losing control leading to losses, investors need to clearly understand how to trade appropriately for each market.
What is hedging forex?
Hedging is a strategy used to protect traders’ portfolios. To avoid potential fluctuations in the market. This is considered a type of insurance to minimize risks and stabilize finances.
In Forex, Hedging is also applied as a way to minimize risks in foreign exchange trading. When the market fluctuates suddenly, we often use it to protect our position. This is usually done by opening two simultaneous buy and sell positions on the same currency pair. The purpose is to ensure that the trader’s position is protected.
For example, if you buy and sell the same currency pair simultaneously, regardless of the direction the price moves, your position will be protected until the right opportunity arises. Then, one of the two transactions will be closed. At the same time, the remaining trading will continue until there is a breakeven point or profit.
What is the Hedging Tool? How do you apply it to forex trading?
The Hedge Tool is a means used to minimize investment risk. This method is commonly applied in many markets. In the Forex market, hedging measures are often more diverse.
In the Forex market, Hedging is often applied in the following three specific situations:
- Short-term protection: Investors use hedging to deal with news or events. These types can cause sharp fluctuations in the market in the short term.
- Position protection: In cases where market movements are unfavorable, investors still expect the price to move in the desired direction. They use it to protect their investment positions.
- Minimize losses: When current investment orders are experiencing large losses, investors can use Hedging to minimize losses from these positions.
See more: Master the Forex “game” with Price action
Effective forex hedging strategies
Currently, the Hedging strategy is becoming popular in the Forex market. However, to implement this strategy, investors must choose brokers that allow Hedging in Forex transactions. Otherwise, they may face the risk of being suspected of fraud. Their account may be locked immediately after applying Hedging. Usually, there are three popular Hedging strategies as follows:
Perfect Hedging Strategy
This strategy is known as Perfect Hedge. It helps to completely protect a position against fluctuations in a currency pair. This is done by opening Long and Short positions on the same currency pair with the same volume and price. This creates a comprehensive defense mechanism. Eliminates all risks. However, it cannot be guaranteed to bring complete profits.
For example, if you have the EURUSD currency pair and want to enter a trade at $X price in a Short position. You plan to trade before the Jackson Hole conference with a volume of 10 Lots. You predict the exchange rate will decrease to Y$. However, this conference often creates big fluctuations in the market. In this case, you would implement the Perfect Hedge strategy by opening a Long position at the same price Y$. Have a volume of 10 Lots on your EURUSD currency pair. This means you will take a Short position and hedge against volatility with a Long position.
Imperfect Hedging funds technique
This strategy uses forex options contracts to partially hedge a position. Because it only protects part of the position and can eliminate some risks as well as some potential returns. That’s why it’s called imperfect hedging.
For example, when in a Long position, a trader establishes a trade with the price of the Euro at a level above X of Z$. If the price of the euro falls below $X, they will immediately buy a put option contract. To minimize the risk when the price of the euro decreases.
Options contracts have the characteristic of having rights but not obligating obligations. In this situation, if the price of the Euro continuously rises above Z$, the trader simply pays the premium for the option contract without having to exercise it. Conversely, if the price of the Euro falls below $X, they will have the right to exercise the option contract to avoid losses. Traders must accept reduced profit margins when executing options contracts in both of the above situations.
Hedging forex on opposing currency pairs
Consider the following example to better understand the Hedging strategy on Forex:
Examples of some variations
Taking the example of the USD, there is a group of major currency pairs. For example: USD/CHF, EUR/USD, USD/CAD, AUD/USD, NZD/USD, USD/JPY, GBP/USD. Among them, two pairs especially fluctuate strongly against each other: EUR/USD and USD/CHF. When one of these two pairs decreases in price, the other pair usually increases in price and vice versa.
Therefore, to hedge strong inverse currency pairs, you need to open a Long order on pair A and at the same time Long on pair B. Do the same with a Short order. For example, if you predict EUR/USD will increase in price, you will also open a Long order for USD/CHF.
Fees need to be paid
With the above example, when buying 1 Lot Long EUR/USD and 1 Lot Long USD/CHF, you will have to pay the following fees:
Swap Fee:
- For EUR/USD Long order: -5.58 Points = -5.58$
- For USD/CHF Long orders: -0.09 Points = -0.98$
- Your total daily Swap will be: -6.57$
Pips fee and Lot fee – value difference:
- Per Pip per Lot EUR/USD: $10
- Per Pip per Lot USD/CHF: $10.98
- When the volatility rate is the same for both currency pairs, you will lose $0.98 for every Pip that fluctuates. At this point, you will make a profit when USD/CHF depreciates compared to EUR/USD.
Difference fee of fluctuating exchange rate:
- EUR/USD in terms of volatility is around 87 pips.
- USD/CHF volatility is around 68 pips.
- If the rate moves in the expected direction, the daily spread will be positive 19 pips. But if the volatility is the opposite, you will lose a certain number of Pips.
How to Hedging with Options Contracts
This strategy will be implemented as follows:
- When opening a Buy order: Use by buying a Sell option or selling a Buy option.
- When opening a Sell order: Use by buying a Buy option or selling a Put option.
Suppose you buy the EUR/USD currency pair at 1.1647 and buy a Put option for the EUR/USD currency pair at 1.1500 to perform Hedging. When the rate increases, you can close the original Buy order for profit and not exercise the option.
Conversely, if the exchange rate drops, you can exercise a Sell option at the contracted price to minimize risk. In either case, you will have to pay a fee to buy the option.
See more: Broker XM: Explore the world of Forex fingertips
Notes when performing Hedging in Forex
Depending on the exchange, you may or may not be allowed to use Hedging. Therefore, pay attention to the regulations of each exchange to avoid encountering unwanted risks when making transactions. Reversal candlestick pattern can be used to identify entry points in a Hedging strategy.
The inverse relationship between currency pairs is never 100% guaranteed. Therefore, be careful when applying the Hedging strategy. Because both orders can go against your prediction. Before starting real trading, you should test it on a demo account to practice your skills.
Remember that when using Hedging, you will open 2 orders at the same time and have to pay 2 Spread fees. Therefore, choose low-volatility currency pairs to apply this method to reduce risk.
At the same time, you need to be decisive and confident in your decisions. Please make the right judgments when choosing orders to maintain. However, hedging should not be overused. Because if you do so, your account may stagnate and make no progress. If you use this method regularly, consider carefully to avoid wrong trading decisions that lead to capital losses.
Conclude
Hopefully, this article from Forex Trading will provide you with useful knowledge. This has helped you clearly understand Hedging, strategies, and things to keep in mind when applying this method in the market. I hope you will use Hedging wisely and achieve success in your trading journey.
Frequently asked questions
How does the Hedging method in forex work?
Hedging typically involves opening two opposing positions to minimize risk. For example, open a long position and a short position on the same asset or currency pair.
In what situations is hedging applied in the market?
Hedging is often applied when investors feel concerned about price fluctuations. Or want to protect your position against risk factors.
How to apply Hedging in your trading strategy effectively?
To apply Hedging effectively, investors need to have a solid knowledge of the market and Hedging tools. As well as develop a strategy that suits their goals and trading style.
