HedgingWhat Is Hedging Technique?
Hedging is a trading strategy that does not aim to get you direct earnings, but only to protect an investment from possible unforeseen circumstances such as price fluctuations. This technique was made popular by Futures traders for example; a bakery could hedge their risk on bread production, by buying Futures contract in Wheat. This protects the bakery from sudden increase in the price of Wheat.
Forex often uses this technique to protect already open trades, thereby limiting its current loss. In practice it involves buying or selling certain currencies pairs that are the same as currencies already open, or that are different but closely related to the currencies already open.
When we use hedging on forex with the same currencies already open, it means opening an identical but opposite position to the one in loss. It is logical that our position will be in a loss, but on the other we will gain by freezing the situation momentarily.
How it works
In the event of a short period of instability or a moment of unpredictable volatility, the purpose is to remain neutral in your "inverse" position. Obviously this is done by working on different time-frame/horizons. For example, after taking a long position on a currency pair on a medium/long term time zone, you may want to reduce your risk in the event of a downturn or temporary instability. You can take a short-term reverse position for the same value of what you have invested in your first position, in order to block the situation.
Warning! Not all positions should be kept open at any cost or subject to hedging. Some positions that point to an error inevaluation of the signal which do not depend on temporary instability should simply be shut down.
To do hedging however, you can use different but inversely related financial instruments. For example, it’s universally known that gold is inversely related to the US dollar trend. For these reasons, a hedging technique that is weighted over different time frames could allow us to leverage both instruments, which, being negatively correlated, will allow us to hedge our portfolio against any losses.
Some Defects of the Hedging
It is possible to forget the marginal transactioncost charged by your broker in the form of spreads/commissions, and swaps you will have to account for in your calculations, as improving a position with this technique means doubling the "cost" of eachtransaction.
the Analyst's answerJean Grossett - Financial analyst
Deploying hedging should not be substituted for proper money management techniques.
Deploying calculated stop loss levels is always my first safety measure put in place. However in the event of an error or sudden volatility, closing such a position is a first option. Hedging is a last resort when closing is not possible, may be due to errors from brokers’ server e.g. Trade context busy.
Hedging can be deployed when in a losing or profitable position, it is however preferable to hedge only in a profitable position, as well as know when to exit one of the order. Partial hedging could also be deployed with the opposite order lot size not exactly equal to the first order. Exiting a profitable order by simply closing it is preferential to hedging it.
In conclusion, it is important to take note of transaction cost in the form of spread, as well as the distance in pips between orders.