In trading currencies or any underlying asset, varying levels of risk are always involved. There’s no way we can forecast the movement of a currency in the future. What we can do, however, is limit risk by employing hedging strategies to protect our investments.
There are many techniques used to hedge a position; but the logic behind is simple: when you are in a long position in a specific currency pair, you’d take another position that would protect your trade should the currency pair moves downward. Thus, you limit the downside risk of your initial position. In the same way, if you are in a short position, you take on another position to protect your trade from upward risk.
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Here are the common methods used to accomplish a Forex hedge:
Simple Forex Hedging
If you’re new to hedging, you may want to try it using a simple strategy first. Simple forex hedging is sometimes called direct hedging. This happens when you have a long and short positions on one currency pair.
Say for example, you are long on EURUSD at 1.30; and it started to move against you. What you can do is open a short position on EURUSD at perhaps 1.28. If you think the exchange rate is on a downtrend, you can close the long position at a loss and let the short position run at a profit. However, if you’re not really sure which way the exchange rate is going to move, you can leave both positions open until a signal prompts you to close or set a stop to both or any position. Whichever is the case, the initial long position’s losses is offset due to hedging.
If you purchased a forex options, you have the right, but not the obligation to buy or sell a specific currency pair at a specified time in the future. How will this help you manage risk of your forex trades?
Say for example, you are long on EURUSD at 1.35. What you will do is purchase a forex strike option at 1.34. This way, if the currency pair goes up, you profit from your long position and just lose the purchase price of the option. However, if the currency pair moves down, you profit from the option and lose on your long position. How much you will profit depends on the size of the option as well as how far down the currency moves.
Trading Multiple Currency Pairs
Another way to minimize risk in forex trading is to trade multiple currency pairs. Say for example, you are in a long position on EURUSD; and it starts to move against you, you could open another long position on USDCHF. EURUSD and USDCHF are historically proven to have a high inverse correlation. That’s why these pairs often move opposite each other. Another way you can hedge an open position is to look for currency pairs with high correlation. Say, you have an open long position on EURUSD and it started to move against you, you can open a short position on GBPUSD.
If you’re going to use this hedging strategy, make sure that you have ample knowledge on currency pair correlation. The major disadvantage of this hedging strategy is that the correlation can weaken anytime. Furthermore, even if your losses are minimized, so will your profit also.
Even though hedging sounds like the greatest thing that ever happened to trading, you have to remember that it involves risks of its own. Exercising due diligence and common sense still goes a long way.Get the 5 most predictable currency pairs