Forex trading is an activity that comes with a lot of risks. While traders do realize this, most would do all they can to minimize, if not eliminate these risks. There are many ways to do this, and one of the most popular is through hedging. In this article, we will talk about hedging and how it works in forex trading. We will go through some of the pros and cons of this strategy as well.
What Is Forex Hedging?
Hedging is a risk management strategy that traders use in order to reduce the financial risks of trading. Some traders have also taken hedging up a notch. Instead of just a precautionary measure, it has also become a profit enhancing strategy for a lot of forex investors.
The forex market is known for its volatility, which means price fluctuations can happen a lot. Sometimes, these fluctuations can be good but in other cases, they can result in massive losses. What hedging does is to protect against the risk of possible losses. It’s a lot like taking out insurance against fluctuations in currency exchange rates. You do this by opening positions in addition to your primary positions, which would serve to compensate for possible losses. Hence, in case prices change unexpectedly, you will have a safety net to fall back on.
Pros and Cons of Hedging in Forex Trading
Just like any other strategy in forex trading, hedging comes with both pros and cons. When used properly and given the right circumstances, it can be a very useful tool to mitigate risk and even enhance profits. At the same time, it can also lead to your downfall. Following are some of the most significant pros and cons of forex hedging that you should carefully consider.
What Are the Pros?
- Minimizes losses:As we have said, the primary purpose of forex hedging is to protect against the potential risk of losses. By creating a safety net through opposing positions, you can reduce the risk due to fluctuations.
- Adapts to market changes:The forex market can easily be affected by external factors like political events, economic situations, and so on. Hedging allows traders to modify positions based on these changes.
- Minimizes emotional trading:Market fluctuations can be stressful, and stress leads to unwise trade decisions. Hedging, however, keeps traders detached since they already know that their positions are well protected.
- Diversifies risk:By holding both short and long positions, you diversify risk across different assets. Essentially, you are minimizing the adverse effects of unfavorable price movements on your portfolio.
What Are the Cons?
- Increases trading costs:Most forex brokers typically charge extra transaction costs for hedging, in addition to the usual trading fees.
- Reduces profit potential:It’s true that forex hedging might be effective in minimizing losses. At the same time, they can also reduce your profits. For instance, you might profit significantly on one position but the hedge position would take losses, so your overall profits won’t be that high.
- Decreases market trend exposure:There are times when the forex market moves steadily on a positive route. You can lose the chance to profit from these market trends if you have too many hedge positions open.
Different Kinds of Forex Hedging Strategies That Traders Use
There are a few kinds of strategies that traders use to hedge in forex. Your choice would depend on a number of factors, such as your trading goals, your risk tolerance, market conditions, and so on. Here are some of the most popular forex hedging strategies you can try.
Simple Forex Hedging
The simplest hedging strategy is to open opposite positions on a currency pair at the same time. For instance, you might buy and sell the same amount on a certain currency pair. It sounds counterproductive to making a profit but this actually protects you from sudden price changes.
Multiple Currency Pair Hedging
Instead of taking opposite positions on the same currency pair, in this method, you can practice hedging by buying and selling correlated forex pairs. For example, the EUR/USD and GBP/USD pairs often move in similar veins. You can go short on EUR/USD and long on GBP/USD to offset any potential loss.
Forward Contracts
These are contracts or agreements to exchange certain currencies at a set date in the future, at a rate that has already been pre-determined. Let’s say the contract is for six months. We all know that a lot can change in the price of the currency pair during this period. The forward contract locks in the current exchange rate, which will apply at the end of the contract. This protects you from possible disastrous fluctuations.
Options Hedging
This is similar to a forward contract, except that it is not mandatory to pay the rate that was agreed upon. If the market fluctuations turn out to be favorable for your trade, then you can use the actual rate instead of the one that was agreed upon. Of course, this option comes at a cost, which can be steep depending on your forex broker.
Brokers That Allow Traders to Practice Forex Hedging
Forex hedging is not an illegal activity but some brokers do not allow it. If you want to incorporate it into your forex trading strategies, you must pick a broker that permits it. Here are some excellent ones that you can choose from.
Pepperstone
An Australian broker renowned for multiple trading platforms and competitive spreads, Pepperstone has licenses from several top-tier regulators.
Fusion Markets
Also popular for tight spreads that start at 0.0 pips, Fusion Markets is another great forex broker that allows hedging. They have more than 90 forex pairs available for trading and they do not have a minimum deposit requirement.
IG Group
IG offers a wide range of trading assets, including nearly 100 currency pairs. It also allows hedging strategies on its platform. All you have to do is turn on the force open setting, which allows you to enter opposing positions. It is also very highly regulated and is known for excellent trading platforms.
FOREX.com
FOREX.com offers a variety of hedging strategies, such as options, derivatives, and CFDs. It supports several top-notch platforms and also offers more than 2500 tradable instruments.
