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Forex Hedging Strategy: Use it to Reduce Losses and Maximize Profits

Forex Hedging Strategy: Use it to Reduce Losses and Maximize Profits

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Estimated reading time: 5 minutes

As new traders in the Forex market, you may have participated in Hedging without knowing.

As a beginner in Forex, i was already hedging without realizing. I frequently use it when ever i think  that i have entered the wrong trade or suspect that something unexpected would happen in the near future.

What is Forex Hedging

When you trade an asset in different directions almost at  the same time, it is described as “hedging”.

This means that when you go long on GBP/USD and almost at the same time, short on GBP/USD or other correlated pair of the Great Britain Pounds, you’ve hedged your trade.

By utilizing Forex hedge effectively, you prevent the the downside risk and upside risk of your long and short positions respectively. forex hedging strategy

In essence, one open position must be in profit while the other in a loss. How much profit or loss (in pips) depends on the market volatility,  the entry time and the currency pair involved.

Some brokers may allow you to open trades that are direct hedges. This means that they can allow you to simultaneously open two trades in different directions on the same currency pair.

Though this strategy gives you a net profit of zero while the positions are open, you can still make profits if you have an adequate timing of the market.

This method of trading is mainly used as a means to protect your open trades from further losses resulting from unexpected or high impact market news release.

How to use the Forex Hedging Strategy

Forex Hedging may not be as simple as you think because there’s a particular strategy you have to follow in order to make the best out of the system.

The main objective of using this strategy is to minimize loss and profit is only secondary but with proper technical analysis and experience, the main aim of using this strategy may be to make profits.

Maximize Profits with the Strategy

It is easy to make profits using this system as long as you have a sound technical analysis.

By using a Forex broker that accepts hedging, open two trades that are direct hedges.

Leave the trades to run for some time ( depending on your analysis).

When you think one of the trades have reached it’s highest high or lowest low and likely to reverse, close the second trade in profit and wait for the losing trade to turn to your favor by a certain number of pips (depending on your analysis).

Then, close your trade either in loss, break even or even profit.

Overall, you’ve made a profit regardless of whether you lost the second trade or closed it at break even.

Let’s give an instance:

Say you opened two positions Buy and Sell  EUR/USD (same lot sizes) both at 1.4000.  You allowed the trades to run for 1 day (depends on your analysis).

After 1 day, the current price of EUR/USD is 1.3000. This means that the long position is losing by 100 pips and the short position is gaining by 100 pips. Floating net profit remains zero.

At this point, if EUR/USD is strongly oversold and likely to reverse or by any other analysis, you detect that EUR/USD is likely to rise – you just need to close the short position in profit of 100 pips and leave the long position to run.

After a reverse in direction of the pair, say the bullish position has now returned to 1.3930 (-70 pips) loss. You can now close the trade in loss of -70 pips, wait for break even or even for a few pips profit on the long trade.

  • When closed at a loss of -70 pips, you make a net profit of +30 pips compared with your previously closed short trade.
  • When closed at break even, you make a net profit of +100 pips
  • When closed at a few pips in your favor, you make a net profit of +100 pips + “value of the few  positive pips“.

 

Minimize losses with the Strategy

The original purpose of using the Forex hedge strategy is to protect you from unexpected losses.

This is how it goes:

Say you went long on the GBP/USD at 1.6000 at a particular lot size – After 24 hrs, the current price of the pair is at 1.5000.

Based on your analysis, you realized that you’ve made a wrong trading decision and the trend direction is likely to remain bearish.

Your next action was to hedge that open position with a new sell position of same lot size at 1.5000 .

This will make your floating loss to remain at -100 pips with every movement in the GBP/USD pair in both directions.

Even when the pair has gone as low as 1.3000, your loss was not increasing and when the price starts heading to 1.6000, you can close your short position at a profit before it goes back to 1.5000.

You now wait for the appropriate time to close your bullish position.

 

General Notes about Forex Hedging

  •  Don’t hedge on multiple currency pairs

A Forex trader can decide to hedge a particular currency by using two different currency pairs. For instance, you could go long on GBP/USD and short on USD/JPY at the same time. In this scenario, instead of moving at the same rate, you will be exposed to fluctuations in the GBP (Great Britain Pounds) and JPY (Japanese Yen).

This is not a reliable strategy for hedging because if  GBP becomes stronger than all other currencies for a particular period, this effect will not be seen in the USD/JPY pair.

  • You must Know the Risks Involved

A trader must properly analyze the market. Therefore, before deciding to hedge a trade, make sure that the potential risks for loss is by far less than that for profits.

After implementing this forex hedging strategy, always monitor it and make sure that the long term benefit is more than the loss.

  • Broker Factors

Not all brokers accept the feature of forex hedging. Even with those of them that accept it, sudden widening in the spread value could cause margin to diminish and therefore expose your account to the danger of margin call.

Apart from that, pip costs and rollovers are other broker-related factors that could cause your equity to decrease thereby adversely affecting your hedged trades.

A perfect example of a broker that allows all types of hedging techniques with minimal pip costs, rollovers and fees is XM.com.  You should use them if you want to practice any type of forex hedging technique effectively.

 

Contrary to what majority of trader think about forex hedging, it is not recommended for all categories of traders. It should be used only by professional and experienced traders especially those that have mastered the behavior of certain currency pairs.

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