If you’ve heard mention the word hedging or cover and you’re not sure what this exactly when we trading, this article can help.
As has been normal in my post, an example to lower it to the ground. Imagine that you have bought a car or a house. When we buy an asset of this type, we normally want to protect our investment from possible accidents or situations that may occur against us.
One of the simplest ways to protect these assets is by hiring an insurance policy that allows us to reduce the possible losses that we could have if an unexpected situation occurs that sometimes we cannot avoid. In trading, hedging works in a similar way.
It is simply an investment to offset or protect our funds, reducing the risk of price movements against us. In this way and simply put, investors or traders use hedging to reduce and control their exposure to risk.
A very important aspect when using a hedging strategy lies in the fact that as you reduce the potential risk you also reduce the potential gains. This is because, like an insurance policy, the coverage is not free.
The hedging can also be achieved by opening a position in another financial asset that has a negative correlation with the vulnerable asset, ie, the initial investment we want to protect. In the case of Forex, we say that two currency pairs have a high negative correlation if the correlation is negative and above 80 generally, in this case the pairs move in opposite directions.
For example, in the currency market, the pairs with a high negative correlation are usually the EUR / USD pair and the USD / CHF pair.
Anyway, I leave you a complete article that I wrote about correlation in forex and how you can consult it at every moment of time (you don’t have to do the calculation manually). It is an important concept.
Before continuing, it is important that you know that hedging is not allowed in the United States . This is because brokers that operate in that country must comply with the “no hedging” rule known as FIFO (First in, First out. First in, first out) of the NFA (National Futures Association) .
This “no hedging” rule only allows you to have one open position on the same symbol. If, for example, we open a buy position on an instrument and then open a short on the same instrument with the same volume, the initial position is closed because one order cancels the other.
Due to this limitation, brokers that are regulated by the NFA normally have international affiliates for their clients outside the United States.
1. Advantages and Disadvantages of Hedging
Like any strategy, hedging has its advantages and disadvantages. Depending on your trading system, it may make sense to apply it or not (I don’t use it, I’ll tell you about it later).
The main advantage of hedging is that it limits losses, but as I was saying it also erases a portion of our gains.
Although it is a fairly conservative trading strategy (a priori), it allows us to have a high hit rate, although it reduces the profit / risk ratio.
Hedging increases liquidity in the market because it implies the opening of new clearing operations. However, this represents a disadvantage as a trader because you will pay more commissions .
Although we can do it on almost any platform, some brokers do not allow it, keep it in mind before applying it.
A clear disadvantage that we must always bear in mind is that not all risks can be covered.
2. Types of Forex Hedging Strategies
The types of hedging strategies are varied and although they all seek to reduce risks and limit losses, each of these strategies can achieve its objective in different ways.
Let’s see the most common strategies used when trading:
2.1. Total coverage
As its name suggests, when we fully hedge we keep the same volume open in long and short trades.
A full coverage allows you to block your exposure in the market, that is, raising or lowering the asset in question will not affect your account. Be careful because a trade with a fixed profit and loss level could reach its stop or take profit and close (and you can keep the opposite trade open with a negative float and no coverage).
2..2. Partial coverage
With a partial hedging strategy, you have long and short positions open, but with different volumes . Here there is already risk (the difference between the volume of one and another position of the same asset that you have opened.
The correlated hedging strategy is one of the best known in trading. Although I already mentioned this strategy at the beginning of the post, let’s dig a little deeper.
It consists of hedging an open trade with another trade in a correlated currency pair. The correlation between both currency pairs or assets can be positive or negative.
In Forex, an alternative is to trade “strong” currencies against “weak” currencies and thus maintain less exposure with strong rises or falls. Let’s say for example that you decide to go short on the EUR / USD pair. Currency pairs like AUD / USD and GBP / USD have a high positive correlation with EUR / USD, so their price is likely to fall as well.
If you open another short in AUD / USD or GBP / USD, you are more exposed in the market because of the short positions in EUR / USD that you already have.
In the case of currency pairs with a high negative correlation such as EUR / USD and USD / CHF, if we open a short on the EUR / USD and go long on the USD / CHF we would also be incurring a greater risk.
Here, we can perform correlated coverage . The important thing is that you take into account the following: if the correlation is positive, to carry out the coverage you must operate in opposite directions (sell – buy or buy – sell) and if the correlation is negative you must operate in the same direction (buy – buy or sale – sale).
2.4. Direct coverage
It consists of opening positions in the same currency pair . It may seem a bit confusing or pointless, I explain it better with an example (of course):
Suppose you are long on the EUR / USD pair, the position is in the green but it has not yet reached your take profit. The publication of a high-impact news is approaching (for example the NFP or GDP) and you want to partially protect your earnings without closing the position. One way to protect yourself from movements due to the high volatility that this news can generate is to open a short position in the same pair and when the volatility decreases, close the hedge position. Minimizing in this way the potential risks of the news.
Direct hedging is also often used to take advantage of corrective movements in a trend. Anticipating a possible price correction in an uptrend, we can hedge a long position by opening a short position. If the correction does take place, we make a profit on the short position while holding the long position.
2.5. Hedging with Futures
Hedging operations with currency futures are one of the most used hedging by large market operators .
Suppose an investment fund, based in the United States, invested in a Japanese company and generated 1 million yen in unrealized profits. As the mutual fund needs dollars instead of yen, it can buy futures contracts of the USD / JPY pair on the exchange for the total amount of yen that you expect to receive (full coverage) or for a percentage of the total to receive (partial coverage) . In this way, the fund ensures a fixed rate for its yen, protecting itself from the risk associated with fluctuations in the USD / JPY pair.
3. Hedging yes or no?
From my experience I consider that every trader must know and know how to apply the different strategies around hedging, especially in a market as volatile as the Forex market.
The main objective of hedging is to minimize the risks of movements against us when making an investment and at no time does it seek to maximize potential profits, so we can consider it a purely defensive strategy .
It allows us to manage our positions in a calmer way, reducing the stress of the psychological factor when we trade. There are many hedging strategies depending on the financial instrument you are trading.
4. Robots that use Hedging
There are many systems on the Internet that may seem very attractive but that constantly hedges delaying losses and adding more and more positions . You can imagine how this ends.
Run away from these types of robots. And you wonder, how to detect them? Easy, don’t buy any forex robot that you don’t know how it is created, how it works and you have spent time testing. That’s for not telling you directly not to buy a robot to trade.
5. My opinion
As you know, I do algorithmic trading and none of my systems apply hedging . They could tell you that psychologically this technique prevents you from closing at a loss and …
I ask you, why not take the loss and delay it by taking on more commissions?
It doesn’t make any statistical sense in that case. Applying currency trading systems individually no. Hedging can make sense in correlation strategies as we have seen between assets or in our portfolio of stocks to protect us from currency risk. If, for example, we buy shares in dollars but our account is in euros. In these specific moments it seems to me a good tool, not for trading systems.
What is your experience with hedging? Do you apply it? I read you in comments!
Thank you for reading!