When you are researching for brokers to sign up with, you might have observed that there are brokers who allow hedging, and those who don't. What is hedging? This article will introduce you to the concept of forex hedging strategy and some of its basic methods.

When you are researching for brokers to sign up with, you might have observed that there are brokers who allow hedging, and those who don't. What is hedging?

Hedging refers to strategies done to limit forex trader's risk that might appear from an unadvantageous price movement while there are open positions on board. Normally, trader's losses will stop when stop loss is touched or margin call occurred. However, hedging enables forex traders to minimize loss or reach break even point. There are some methods on how to hedge against unfortunate price fluctuation that might harm you.

hedging in forex

 

Forex Hedging In The Same Currency Pair

As the name suggests, hedging in the same pair is done by opening a new position in the exact same pair you have already opened before. This is the simplest form of forex hedging strategy and sometimes called as direct hedging.


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Say, you expected the USDJPY to go down from 103.75 to 103.49, so you sell the pair. After a while though, the price moves upward, even breaks the previous resistance on 103.87. Still, you are not sure whether the move is real or if the price will revert downward later. To hedge your way, then you opened a buy position in the same currency pair. That is hedging. In addition to opening a new position to the opposing direction, you could also add a stop loss to both orders, up to a certain level at which you could consider the direction is confirmed either up or down.

But this is actually a risky move. If price moves erratically and you don't see any confirmation until it is too late, both stop loss might be touched, and you might gain double loss compared to if you did not hedge, as much as the gap between both positions. Personally, I have never been able to successfully do this, so I don't suggest it to you.

 

Forex Hedging In Different Currency Pairs

The second method in the forex hedging strategy is by hedging through different currency pairs that have a high correlation between one another, either negatively or positively. Some brokers forbid the use of forex hedging in the same currency pair but allow hedging if it is in different currency pairs.

As you might have noticed in your trading platform, there are some pairs that often move in different directions, or conversely, moves in exactly the same direction up to a certain degree. In the following graph, there are several pairs that have more than -80 hourly correlations. That means, they are negatively correlated; when one pair moves upward, the other one tends to move downward, and so on. 

Hourly Hourly Correlation Of Several Currency Pairs Processed Through Tool in Forexticket.com; There Are Also Daily And Weekly Correlation

As you can see in the chart, USDJPY and AUDUSD have a -86.6 correlation; that means, you can hedge the USDJPY position by using AUDUSD, or vice versa. In the USDJPY case before, instead of opening another position on the same pair when USDJPY goes up, you could opt to hedge with AUDUSD. Open a long position in the AUDUSD pair which probably would profit in the next few moments, closing up the losses you have suffered at the hands of USDJPY.

The trouble with this method is that inter-pair correlation changes from time to time. When I wrote this article, USDJPY and AUDUSD have a high negative correlation, but it might change in the next day or next week. The correlation might weaken or turn into fifty-fifty. Nevertheless, I consider this forex hedging strategy as better than the first one.

In order to actually make it, consider hedging between currency pairs that are famous for being negatively correlated, like the GBPUSD and USDCHF, or between pairs that are famous for having a highly positive correlation, such as GBPUSD and EURUSD. Remember that if you hedge in positively correlated pairs, then you should open position to two different directions (long and short). But if you hedge by using negatively correlated pairs, then you should open position in the same direction (long and long or short and short).

 

Forex Hedging With Binary Options

Hedging could also be done with binary options. Binary options refer to trading practices on the expected price movement of forex in a certain period. Binary options trader bets a certain amount of money, then choose a call option when he thinks that the price will move up or put option when he thinks that the price will fall. Afterward, he will gain almost double the initial capital if his prediction is true, or lose more than half of his money if his prediction turns out wrong.

Binary options are traded separately from ordinary forex trading. There are specific binary options brokers, but there are also forex brokers who offer binary options trading in a separate account. This method requires you to have binary options trading account besides your ordinary forex trading account.

Forex hedging with binary options could be done both in the same currency pair and in different currency pairs. The method is similar to how they are done in ordinary forex trading. The difference is that you hedge the first position by opening another position in binary options. Although the first position might end in loss, the second position in binary options is said to have a considerably high possibility to succeed. But, well, you'd better have practiced binary options first before trying to do this. Binary options is not as easy as it sounds.

 

Besides these methods, there are also forex hedging by opening positions in three currency pairs at once (three pairs hedging), and some relatively more complicated methods. Forex hedging strategy is basically a strategy to secure the already-opened position and minimize your losses while trying to gain the upper hand from the gap between the first loss and the second profit. Therefore, there are plenty of ways to answer the question of how to do it.