What Is Forex Hedging
The goal of hedging in the forex market is to turn losing trades into profitable ones, or at least to exit a trade with the smallest possible loss. It helps to understand Top 8 Global Forex Brokers.
This article explains what hedging is, some of the strategies used with it, and how it differs from cooling (offsetting) and scaling in (reinforcement).
What is hedging in forex?
Hedging means strategically opening additional trades in order to reduce a loss and protect the account balance.
Note: in Arabic this practice is called “al-tahawwut,” a translation of the English word hedging, which is the more common term.
In other words, hedging is one of the financial tools that fall under risk management. Through hedging you can balance a losing trade against a winning one to come out with the smallest possible loss. But it is not that simple: hedging has to be based on a clear strategy, not used haphazardly.
Read also: What is a broker and its role in the forex market
Hedging, cooling, and scaling in: what’s the difference?
Scaling in (reinforcement)
This means increasing the number of contracts you currently have open in order to add to your profits. It is used when the market moves in the same direction as your existing trades.
For example, if you analyzed EUR/USD and expected the pair to reach 1.2100, entered a buy at 1.2000, and after the price moved to 1.2050 (50 pips) you opened another contract on the same pair in the same direction as your current trade, that is a scaling-in contract.
Cooling
Cooling means opening contracts in the opposite direction to your current trade in order to limit the loss.
For example, if you bought EUR/USD at 1.2050 and then the price reversed until it reached 1.2000, a loss of 50 pips, you can open a new contract in the opposite direction of the current one at 1.2000, provided you expect the price to fall based on new information in the market. This is called a cooling contract.
Hedging
This is the hardest of the three, because at times you may sell and buy the same pair at once to reduce the loss and protect the account balance.
For example, if you open a long-term buy trade on EUR/USD, and after the price rises a few pips the direction changes and the price is expected to fall based on other information in the market, you can open short-term trades in the opposite direction of your current trade. These contracts are called hedging, because you are balancing the winning trade against the losing one to protect your account balance. You may even make a profit by closing the losing contracts and leaving the winning ones open.
Hedging in forex is a double-edged sword
Hedging in the forex market differs slightly from hedging in other markets, because forex is volatile by nature, unlike more stable markets such as stocks and bonds. So here hedging is a double-edged sword: it can increase the loss instead of limiting it. For that reason, some forex traders decide not to hedge their trades, believing that volatility is an inherent part of currency trading, and so they accept the full loss without any attempt to reduce it.
Read also: The most widely used technical indicators in forex
Professional hedging strategies in forex
There is a wide range of risk-management strategies forex traders can use to control their potential losses, and hedging is one of the best known. The most popular hedging strategies are direct hedging and multiple-currency hedging.
Direct hedging strategy
Direct hedging is one of the simplest hedging strategies, because the hedge is placed on the same currency pair as the open trade, but in the opposite direction to the current trade.
For example, if you have a long-term trade currently open and it is now at a loss, you have two scenarios. The first is to accept the full loss, or close the trade as it stands. The second is to hedge by opening short-term trades in the opposite direction of your current trade, so you balance the profit against the loss and protect your capital.
Remember that closing the trade without considering a hedge means you accept the loss, whereas if you decide to hedge you may get a second chance to recover your money.
Multiple-currency hedging
Multiple-currency hedging means buying and selling a single currency across two currency pairs, such as buying EUR/USD and at the same time selling USD/CHF. Here you have hedged one currency: the US dollar.
The one drawback of this type of hedging strategy is that you are exposed to exchange-rate fluctuations in the euro and the franc.
In other words, if the euro rises against all other currencies, the hedge can fail and the loss can grow. So hedging more than one currency pair carries high risk. On the other hand, one position may make a profit that covers the loss and even exceeds it.
Read also: Types of trading strategies in forex
Who can hedge?
Most hedging is done by professional traders, because hedging strategies require a deeper understanding of the financial markets. That does not mean intermediate traders cannot hedge, but they should have at least a basic understanding of how the market behaves, along with a clear trading plan. It is better for them to avoid multiple-currency hedging and stick to direct hedging at first.
Things to consider before hedging
Choosing the currency pair
As noted above, the forex market differs from other markets: it is volatile by nature, unlike more stable markets such as stocks and bonds. Since currency pairs are not equally stable, hedging on the wrong pair may make things worse.
Example: EUR/USD does not have the same stability as GBP/JPY.
So before hedging, make sure the currency pair is not highly volatile. You can choose any of the major pairs, which usually have high liquidity and are therefore less prone to volatility and price slippage.
Amount of capital
Another point to consider is capital, because opening a new trade requires more money so that you avoid wiping out the account entirely.
Key takeaways
Forex hedging is often a complex approach that requires a lot of understanding. Here are some key points to keep in mind before you start hedging:
- Hedge strategically, based on a clear plan, not haphazardly.
- Some forex traders do not hedge, because they believe volatility is a fixed part of forex trading.
- There are several hedging strategies; the best known are simple forex hedging (direct hedging) and multiple-currency hedging.
- Before you start hedging in forex, it is important to understand the currency market, choose the right currency pair, and consider how much capital you have available.
- It is a good idea to test your hedging strategy before trading in live markets.
Frequently asked questions about hedging
What is hedging and what is it used for?
Hedging means a trader takes two opposite positions at the same time on the same financial instrument. It is used to turn losing trades into profitable ones, or at least to keep losses to a minimum.
What is hedging in stocks?
Hedging is a single concept: a position taken to prevent losses caused by price fluctuations, or to avoid exposure to market risk.
What is the role of hedge funds in financial markets?
A hedge fund is a protective portfolio, an investment fund that holds different financial instruments and aims to deliver a return higher than traditional instruments without bearing the same losses.
What are financial derivatives?
They are complex instruments used for hedging: contracts between two parties whose value is linked to the value of an underlying asset, meaning they are tied to a fixed price and a specific future settlement date.
What are hedging instruments?
There are many financial instruments and investment assets that serve the goal of hedging, including insurance policies, futures contracts, investment funds, and swaps.
How do hedge funds work?
A hedge fund is a pool of financial instruments contributed by investors under the supervision of a fund manager. Its aim is to grow financial resources beyond the returns of traditional instruments while keeping risk levels low.
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