Hedging in Forex.
One of the most well-known risk reduction options is forex hedging. It's not only the most well-known option, but also the most controversial. Some traders reject it outright, while others profit solely through it.
Hedging is a method of reducing financial risks in which two transactions are opened in different directions, but in the same volume and for a similar group of assets.
There are numerous examples of hedging, the most obvious of which is reducing currency risks when trading different currencies. For this purpose, two simultaneous buy and sell trades are opened for the same currency pair, each with the same volume. Now, regardless of the exchange rate, the financial result of the transaction will remain the same. This is because the losses from the losing trade are offset by the profits from the winning trade. We'll discuss hedging in Forex in more detail below.
Beyond currency markets, this risk reduction method can be applied to virtually any exchange. This mechanism, known as futures contracts, has been in use for over 50 years.
Scheme of conducting Hedging in practice.
Hedging in Forex is most often used as an alternative to stop-loss and trailing stop orders. Unlike the latter, this method of reducing losses is more flexible and allows the trader to decide when to close a position.
For example,
we first open a one-lot buy trade on the GBPUSD currency pair at 1.5350. To lock in a 20-pip loss, we place a pending sell order at 1.5330.
If the trend doesn't meet our expectations and the pound sterling price begins to decline, the pending sell order will be triggered, thereby hedging, locking in our position. If the price continues to decline, the resulting loss will be offset by the profit from the second order. Even if the price drops to 1.5300, the loss on both trades will still be 20 pips.
After hedging with a sell, the trader must decide which position to keep and which order to close. Obviously, we'll keep the profitable forex order , but before making a final decision, it's important to check whether the trend has actually changed direction or whether it was a short-term price correction.
Disadvantages of hedging.
If this operation is not being conducted for profit, but merely to reduce risks, then everything is simple: you immediately enter into a futures contract and protect yourself from price changes.
When using forex hedging, things are much more complicated, since to make a profit, you must necessarily close one of your positions. And if you make a mistake, you can only increase your existing losses. Therefore, it is recommended to secure your financial result with a second trade only if you are 100% certain of the reversal and know its cause, which requires knowing how to identify a trend .
