Forex Hedging: What is Currency Hedging?
An Explanation of Hedging in Forex
Hedging is a concept that anyone who knows finance or trading should find familiar. The idea is to mitigate against risks you are taking with your investments, by making other investments.
If you recently learned about the foreign exchange, or forex, market, you may be curious about how you can hedge while trading currencies. Using a platform like OANDA makes it effortless to trade, as you can even access margin on your accounts.
What you must not do, however, is put all your eggs in one basket. Even if you are very sure about a specific price moment, do not put all your money into one or two trades.
Below is a guide that explains how to hedge in the forex market.
Hedging in the Forex Market
The concept behind hedging in any market is to mitigate against risks, which is how you should treat it with respect to foreign currencies. The value of currencies fluctuates all the time, which is advantageous to traders but can also result in significant losses if they are not careful.
Any trader must understand that predicting how currencies will move is possible, but knowing when they will move is extremely difficult. Even the most seasoned traders can be wrong about when a shift will occur, and being wrong by hours can cost a lot of money if a trader is only making trades in a single direction.
Assess any chart of major currency pairs, such as USD/GBP or EUR/USD. You will see that even though the price remains relatively stable in the long term, there are a lot of fluctuations throughout the day. Those movements are how traders make money, but if all your trades are in a single direction, then you may lose a lot if the currency trends towards the opposite of your prediction.
Diversify Your Portfolio
The idea is to ensure that your portfolio of currency pairs is very diverse. You are not only trading one or two currency pairs, but six or seven pairs that often go in opposite directions.
What that means is that you must first look at how currency pairs react to certain economic and world events. Currency pairs do not always move in the same direction. For instance, USD/YEN may not move in the same direction as EUR/USD, or GBP/YEN may move in a different direction than EUR/YEN.
Look at the historical trends over the past few years of each major currency pair, and divide them up based on how they are shifting. You will see that certain pairs move in similar directions, while others in the opposite. Now you can balance out your portfolio by ensuring you are trading equal volume from each group, if possible.
Trade Strategically Every Day
Diversifying your portfolio does not mean that for every trade you make of one currency pair, you must then make one from another pair. Perhaps a particular pairing is more volatile today, which is why you are trading it more often. What you must ensure, however, is that you are not putting all your money into those trades.
Ensure that you are only using a set sum for those trades, which you can afford to lose. Keep the rest of the money for trades from the other group, which you can make later in the day or the next day.
Even on days when you are focusing on a particular pairing or two, make a few trades from the other grouping you have put together. If there is a significant event that shifts currency pairings, and your primary bets do not pan out, your secondary bets can serve as a hedge to limit your losses.
Hedging Keeps You Safe
Whenever you make an investment, you have to contemplate the worst-case scenario. We all want to believe that our judgment is sound and that our investments will work out flawlessly.
Even the best-laid plans can go astray. Perhaps you miscalculated the result of an election or the impact of a worldwide event. The markets may move in the opposite direction to what you anticipated.
By hedging when you are trading forex, you can ensure that you have protection against any unforeseen consequences of your trades.