Simple Hedging in the Forex Market
Some brokers allow for direct hedging positions. Direct hedging occurs when you are permitted to place a buy order for one currency pair, such as USD/GBP. At the same time, you can also place a sell order for the same pair.
Although the net profit from both positions together will be zero while both positions are open, you can make more money without taking on additional risk if you time the market correctly.
Hedging Protection
Simple hedging protects you because it allows you to trade in the opposite direction of your initial position without needing to close out the initial trade. One might argue that it’s better to close the initial position at a loss and then place a new trade at a better position. This example is one of the types of decisions you will make as a trader.
Definitely, you can close the initial position and re-enter the market at a better price later. The advantage of using hedging is that you can keep your initial position in the market and make money from a second trade that profits while the market moves against your initial position.
Cancelling the Hedge
If you suspect that the market will reverse and favor your initial position, you can always place a stop-loss order on the hedged position or simply close it.
There are many ways to hedge Forex trades, and it can become somewhat complicated. Many brokers do not allow traders to take neutral positions directly in the same account, so alternative methods need to be used.
Multiple Currency Pairs
A forex trader can hedge against a specific currency using two different currency pairs. For example, you could buy a long position in the EUR/USD currency pair and a short position in the USD/CHF currency pair. In this case, it might not be precise, but you will hedge your exposure to the US dollar. The only problem with hedging this way is that you are exposed to the fluctuations of the euro (EUR) and the Swiss franc (CHF).
This approach means that if the euro turns out to be a strong currency against all other currencies, volatility in the EUR/USD currency pair may not be balanced by your USD/CHF trade. Also, this method is generally not a reliable way to hedge unless you’re building a complex hedge that takes multiple currency pairs into account.
Forex Options
A forex option is an agreement to execute a trade at a specific price in the future. For example, suppose you are buying a long trade position on the EUR/USD currency pair at a price of 1.30. To protect this position, you would place a forex put option at 1.29.
This approach means that if the EUR/USD currency pair drops to 1.29 at the expiration of your option, you will receive an amount of money on this option. The amount you will receive depends on market conditions at the time of buying the option and the size of the option. If the EUR/USD currency pair does not reach that price by expiration, you will only lose the premium paid for the option. The further your option is from the market price at the time of purchase, the more valuable the payout will be if the price is hit within the specified timeframe.
Reasons for Hedging
The main reason for using hedging in your trades is to limit risk. Hedging can be a larger part of your trading strategy if executed carefully. It should only be used by experienced traders who understand market volatility and timing. Playing with hedging without enough trading experience can diminish your account balance to zero in a very short time.
Source: https://www.thebalancemoney.com/introduction-to-forex-hedging-1344819
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