subject: Hedging Strategies for Trading in Forex [print this page] Hedging Strategies for Trading in Forex Hedging Strategies for Trading in Forex
Hedging is a common strategy in the financial markets. To hedge is to essentially reduce your exposure to adverse market movements.
Actually, hedging is all around us. A wheat farmer may sell wheat futures to offset an anticipated decline in wheat prices. The farmer knows that if wheat prices do fall he will get less for his wheat when he goes to market. He also knows that if wheat prices fall he will profit from selling wheat futures as the price declines. In this way he is able to offset some of the income he lost because of declining wheat prices.
There is a similar type of offset that is very common in the stock market. Some refer to it as "portfolio insurance". An investor wishing to reduce his risk may buy index put options so that if the market declines he will profit from the put options and offset the general decline in his stock portfolio.
Strategies to hedge in Forex trading are very common. Let's take a look at some of the more common ones.
Some traders actually trade the same currency pair more than once. A trader will establish a long position in the EURUSD for instance. The trader may then establish a short position in the EURUSD also. Traders using methods such as these anticipate that the EURUSD may not immediately go in their direction. They realize that they may be able to grab 10, 20, or 30 pips from selling the EURUSD before the market goes in their direction. If the trader is able to grab a 30 pip profit on the downside before the market goes up they have just added 30 pips to their bottom line. If the trader is able to grab a 30 pip profit on the downside and the market continues downward they have effectively offset their total loss by 30 pips.
Special Note: Keep in mind that trading regulations change and that this particular type of hedging strategy may or may not be allowed in the future.
It is very common for traders to hedge using 2 or more different currency pairs. To do this requires knowledge of the correlations between the currency pairs involved. "Correlation" is just another way to say, "co relation" or how the currency pairs relate to each other. For instance, does one currency pair's price consistently go up when another currency pair's price consistently goes down? Those 2 currency pairs could be said to have a strong correlation. Once you know the correlation between the currency pairs you can then construct and effective hedging strategy.
When you find 2 currency pairs with a strong correlation you can use the same strategy as previously described using the EURUSD. If they have a strong positive correlation that means that they basically move in the same direction. You can buy currency pair A and sell currency pair B each time you feel that currency pair A might move downward in price.
Hedging strategies in Forex trading can be used in any timeframe. One important thing to keep in mind is that by trading more than one currency pair you will have increased transaction costs. Just make sure that your strategy is one that will allow you to be profitable after all costs are taken into consideration.
