Last updated Apr 19, 2019 Published on Jan 9, 2019All StrategiesForex BasicsForex StrategiesOptions Trading StrategiesStock Trading Strategies
Thehedging strategiesare designed to minimize the risk of adverse price movement against an open trade. If you fear a stock market crash is coming or you just want to protect one of your trades from the market uncertainty you can use one of the many types of hedging strategies to gain peace of mind.
If this is your first time on our website, our team at Trading Strategy Guides welcomes you. Make sure you hit the subscribe button, so you get yourFree Trading Strategyevery week sent right to your inbox.
You probably have heard that in times of distress investors are buying puts to protected profits and hedge risk in case of a sell off. That is one way on how to hedge stocks, but there are other hedging methods to protect your trades.
If youre going to use derivative hedging strategies, you can only do it when youre taking a top-down approach. If youre going to take this top-down approach youre going to avoid those situations where youre increasing your exposure by selecting the wrong instrument to hedge your trades. Also be sure to check our guide on the beststock trading strategies.
Through this article, were going to talk about a Forex hedging strategy and how to use simple many currencies in a hedging strategy.
But, lets first start by discussing what is hedging risk and what a hedging strategy is.
Basically, hedging is when you open trades to offset another trade that you have already opened. The hedging methods require using a second instrument or financial asset to implement risk hedging strategies.
In essence, by opening this trade youre offsetting the risk. Secondly, before opening a hedge trade you need to make sure that there is some sort of negative correlation between the two opened trades.
In other words, the hedging strategies give you the chance to limit your losses without using astop-loss strategy.
The stop-losses are a critical tool used in Forex trading to limit losses if the trade doesnt go as planned. You simply cant be successful in the long-run if you dont limit your downside by using stop losses.
The hedging strategies work the same way as a stop loss order in terms of limiting losses. However, the advantage of hedging is that you can also make money on the hedge trade if you careful select the second trade.
The biggest misconception among retail traders is that theForex hedging strategymeans placing an equal and opposite trade to the one that you already have opened. In other words, if you bought 1 lot of EUR/USD, you would throw a 1 lot sell EUR/USD to offset the first trade. However, thats not how hedging works.
Only the Forex hedging strategy requires holding buy and sell at the same time on the same pair. Forex hedging is used more to pause the profit or loss during a reversal. So, if the market is going up and youre short, you might buy to temporarily hold the position until the market turns back in your favor.
Thats just one angle to understand what is Forex hedging.
Traders can also fall into the trap of thinking that since we are fully hedge, we can just let the trade run for weeks and months without worrying about too much. However, when you rethink that and take into consideration other factors like thecarry cost, the Forex hedging strategy can suddenly lead to bigger losses.
Lets now get into the nuts and bolts of what types of hedging strategies you can use.
If you want to use aForex hedging strategywith a US Forex broker, its not possible. Hedging was banned in 2009 by CFTC. However, if you want to get around the FIFO rule you can use multiple currencies to hedge your transactions.
Now, were going to show you one forex hedging strategy that uses multiple currencies to hedge. You might need to read this a few times you havent read this before.
Just remember that when you buy a particular currency youre always buying one currency and selling the other one. Conversely, when youre selling youre always selling the first currency and buying the other. So, thats one of the checks you need to make.
Lets say as an example of hedging strategies that you buy the USD/JPY. If you want to use hedging strategies you then have to also buy EUR/USD. In this case youre effectively buying EUR/JPY because the USD parts cancel each other.
Now, in order to hedge your trade you need to sell EUR/JPY
Those three transactions together form a hedge.
Because on the EUR you have both a buy and a sell, on the USD currency you also have a buy and a sell, and on the YEN you also have a buy and sell.
This is a perfect hedge and a perfect example of hedging strategies that uses multiple currencies.
Note* When using this hedging strategies, the big trick is to make sure that you buy and sell transactions that cancel each other.
In the picture below you can see a number of hedging alternatives that you can play around.
Lets now look at other types of hedging strategies.
Gold is a perfect hedge if you want to protect yourself against higher inflation.Gold pricestend to benefit when inflation runs out of control. But, Gold is also a hedge against a weaker US dollar. In other words, there is an inverse correlation between Gold prices and the US dollar.
If Gold prices go up, the US dollar goes down and vice-versa.
Historically, Gold has always been perceived as a form of money, which is the reason why its a good hedge against a dollar collapse or against hyperinflation.
Optionshedging is another type of hedging strategies that helps protect your trading portfolio, especially the equity portfolio. You can apply this hedging strategy by selling a put options and buying a call options and vice-versa.
Options are also one of the cheapest ways to hedge your portfolio.
There are many financial hedging strategies you can employ as a Forex trader. Understanding the price relationship between different currency pairs can help to reduce risk and refine your hedging strategies.
By using two different currency pairs that have either a positive correlation or negative relationship you can establish a hedge position.
For example, EUR/USD has an 83% negative correlation with USD/JPY. In this case, you can go long EUR/USD and short USD/JPY to hedge your USD exposure. The only drawback with these types of hedging strategies is that youre exposed to the exchange rate fluctuations in the EUR and JPY.
In other words, if the EUR strengthens against all other currencies, then we can have a situation where the move in EUR/USD is not counteracted in USD/JPY.
Some currencies are more exposed to the influence of theoil price. The more noteworthy example is the Canadian dollar. Usually, there is a positive correlation between the oil price and the Canadian dollar exchange rate.
When the oil price strengthens, the USD/CAD exchange rate will weaken.
In this case, you can use the oil hedging strategy to hedge your exposure on the USD/CAD trade. You can go long USD/CAD and open a short hedging position in Oil.
Retail traders hedge their trades mainly for psychological reasons and not because its a good trading strategy. By being able to use financial hedging strategies we get the feeling that were not wrong about our trades, were just holding for a while and then well take the hedge off when things are going in the direction that we know theyre going to go.
No matter whichtypes of hedging strategiesyou use, you need to understand that there are no free lunches in trading. Hedging is like buying insurance against losses!
The Forex hedging strategy is a great way to minimize your exposure to risk. It not only helps you to protect against possible losses but also it can help you to make a profit.
Feel free to leave any comments below, we do read them all and will respond.
Also, please give this strategy a 5 star if you enjoyed it!
Please Share this Trading Strategy Below and keep it for your own personal use! Thanks Traders!
Diagonal Call Calendar Spread Smart Trading
Williams Percent Range Strategy – 2 Approaches
Descending Triangle Pattern How to Trade like a Pro (2019)
Best Day Trading Stocks with Mountains of Cash
Pairs Trading – The Secret to Cashing Profits
816 Ligonier Street 405 Latrobe, PA 15650 (724)
Disclaimer: Trading carries a high level of risk, and may not be suitable for all investors. Before deciding to invest you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading, and seek advice from an independent financial advisor if you have any doubts.