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How to Use Hedging in Forex

March 14, 2016 by admin in Tips, Trading

forex

Trading in FX is always connected with a risk of loss. That is why many traders use different tools to minimize risks. What is hedging in Forex? What are its advantages and disadvantages? The answers on the questions will be covered in this article.

Definition

Hedge is an instrument that is used on two oppositely directed positions of the same lots on two unidirectional pairs. Hedging is the process of entering a hedge.

The main purpose of the best hedging strategy is to compensate losses in one position by means of profits from others.

For example:

There are 2 currency pairs EUR / USD and GBP / USD. They are unidirectional because if USD goes up, it does so in both pairs. A trader can set “buy” and win, or (if the market changes its direction) lose. But if the trader enters a hedge, his position is saved and he will not lose in any case.

Parallel or mirror movement of the pair’s price is the basis for every hedge strategy. Forex is unpredictable, and such an instrument assists to protect the deposit somehow.

Aims

  • Reducing the risk of loss.
  • Excretion in zero loss-making position.
  • Gaining profits for one or both positions.

What helps to achieve the goals:

  1. Difference in currency pairs’ movements.
  2. Difference in movements’ speed.
  3. Difference in the price.

Usage of hedging

Not only advanced traders know how to use hedging in Forex, but beginners can use this tool as well. Usually they open position in a currency pair, and then they open opposite positions on the same currency pair. This type of hedging protects the trader from getting a “margin call” (forced closure of positions because of insufficient margin), because the second position will show a profit in case the first one suffers losses and vice versa.

Nevertheless, there are many other methods, which may allow traders to profit instead of only compensate losses. Forex hedging system allows users to analyze rates of exchange in a kind of vacuum; it means that they draw a graph only for one pair paying no attention to other instruments. Then they calculate indexes, for example, for the USD and the EUR there are the official indexes, but the trader can easily create his own tools for the analysis of other currencies.

Parts of the strategy

1. Analyzing risks It should be identified how high the risks of the opned and opposed positions are.
2. Determining readiness for hedging If a trader realizes that hedging will really reduce analyzed risks, he can enter a hedge.
3. Determining strategy A trader should have an opportunity to use the strategy in his trading platform.
4. Implementing and controlling the strategy The chosen strategy should work properly: risks should be minimized.

Advantages

  • Reduction of risks.
  • Greater stability and flexibility in planning.
  • Simplification of funding.
  • Empowerment participation in trading real goods.
  • Sharing risks connected with the distribution/delivery and price risk.

Disadvantages

  • Presence of basis risk.
  • Small number of futures contracts.
  • Small number of trading platforms supporting hedging.

Although this strategy is not uncommon, not all brokers give an opportunity to use it. Nevertheless, there is a rating of Forex brokers that allow hedging.