How does Forex Trading Work?

Learn how to Manage and Mitigate Risk in Forex With Hedging.

Hedging is a hot topic for newcomers to the forex market and if used correctly, can be a great way of mitigating your risk and improving consistency.

So what is forex hedging?

Well, hedging refers to opening up an offsetting position in the market to temporarily cover an existing position that has either gone against you or may turn against you.  This could be on the same currency pair, or on another highly correlated pair.

All traders can employ the second strategy, but you will have some trouble with the first if you’re trading from within the United States.

Forex Hedging Explained

Forex Hedging Accounts

If you open a forex account outside the USA, chances are the account will be a hedging account – these are by far the most popular trading accounts and for most brokers this is the default accounting method.

A forex hedging account allows you to be long and short the same asset or currency pair at the same time.

The alternative to hedging mode accounts are netting accounts – netting accounts will not allow you to open an offsetting position in the same asset or currency pair.

If you are long USDZAR and then attempt to short USDZAR at the same time for example, your original long position would be closed and you would no longer have any position in the market.

For traders employing multiple time frame strategies, netting accounts are incredibly prohibitive.  If you had a long term buy position on a market, but wanted to short a temporary top in the trend, you would be unable to execute this plan on a netting account.  You would try to enter short, but you would just reduce your core position.

There is next to no demand for netting type accounts outside the USA (where they are mandated) and lots of brokers don’t even offer them.

Hedging Risk

Hedging means taking one action to offset or mitigate the risk of another.

Let’s now take a look at an example relating to your personal finances.

Personal Finance Hedging Example

Imagine you need new shoes before the weekend and you will be ordering online.

The shoes will arrive in time, but there is some size variation between styles in your favourite brand so you are not sure whether you will be a 9 or a 10.  You know you will be doing a lot of walking over the weekend and won’t be able to return the shoes after they’ve been used if you get the wrong size.

Rather than risk ordering the wrong size and being stuck with them, losing what you paid for shoes that don’t fit, you decide to order both a 9 and 10, and wear the pair that fits, returning the other.

You have just hedged the risk of paying for a pair of shoes that don’t fit.

In finance, hedging is a tactic aimed at reducing the downside of your investments. Whenever you have a position in the market you have the potential to make profit and you also have the risk of losses. The aim of a hedging strategy is to limit your potential losses, without subtracting too much from your potential returns.

In the forex market there are two types of hedging, direct hedging and correlated hedging.  We’ll take a look at each.

Direct Hedging in the Forex Market

Direct hedging refers to having a long and short position open in the same currency pair at the same time and requires a hedging mode forex account – direct hedging is not available to traders in the USA.

Forex Direct Hedging Example

You are pretty sure USDZAR is going to sell off in the coming weeks and don’t want to miss out, but you also have a feeling it’s going to go a little higher first.  The problem is you know once it does sell off, it will happen fast and you will likely miss your entry.

As you can earn interest shorting USDZAR and you don’t want to miss out on the violent reversal, you enter your short position right away.  To mitigate the risk of that short position going against you temporarily while you wait for the reversal, you begin buying dips too.

USDZAR rallies for two more days and you make some profits buying dips, offsetting the losses on your short position while it continues to earn interest.

The last long position you take gets stopped out when the reversal comes, but the gains on your short position + interest + profits from the previous longs more than offset this last loss.

This was a highly successful hedged position.

Correlated Hedging in the Forex Market

Correlated hedging in forex refers to taking an offsetting position in another highly correlated forex pair.

As this involves trading two different pairs, this strategy can be employed by anyone – even traders in the USA.

Forex Correlated Hedging Example

You are long AUDUSD as it is trending up and your position is in profit.  You believe it will keep going higher, but you are worried about the risk of an impending interest rate decision from the RBA which could send the AUD lower.

After looking at some charts you come to the conclusion that if the AUD does fall, AUDJPY will likely fall further than AUDUSD as it is over extended and more volatile.  You open a short position on AUDJPY with a stop above the highs.

If the AUD appreciates after the rate decision, your position in AUDJPY will be stopped out quickly and your AUDUSD position should offset that small loss.  If the AUD however falls like you expect it too, your losses on your AUDUSD long should be more than offset by the gains on your AUDJPY short.

The RBA cuts and AUDUSD falls by 30 pips, AUDJPY falls by 70 pips, you close the AUDJPY position for a nice profit and hold on to your core AUDUSD long as you expect a full recovery and continuation.

Can you see the advantage of hedging your position on a correlated currency pair?

The Goal is to Hedge our Risk in Forex, not Compound our Losses

Though correlated hedging is a little more advanced, it is arguably a more effective strategy.

With direct hedging, you run the risk of compounding a series of bad decisions.  Before you open an opposing position in any one currency pair, you have to ask yourself what your goal is and whether opening a new position will actually achieve that goal.  Or whether you should just be taking the loss on your original position.

If however you are forecasting and trading over various time horizons, direct hedging can be an incredibly powerful tactic to reduce drawdowns and increase returns.

Allowing you to profit when the market rises and falls.

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