The hedging strategy consists to hedge against fluctuations of the exchange rate by taking two opposite positions of a same amount. For example, if you have one long and one short position on the EUR/USD for one lot each, it is said that you’re hedged. In fact, you can neither win nor lose. The balance of your account will be stable. In other words, your risk is zero.
What is the interest to resort to hedging?
The hedging is used to protect its profits and / or to take advantage of corrective movements.
Capital protection :
If your position is hedged, you do not risk anything. Whatever the fluctuations of the pair, your balance will not change. Hedging is used when there are doubts about the future evolution of price and that you want to protect your profits already made in an open position.
Example 1: You’re entered long the market at 1.3950. The price rises and is close to 1.40. You’re not sure of this resistance will be broken or not. You can then hedge your position by taking a short. So you can safely see if the resistance is broken or not. Besides, when you hedge your position, you protect your profits made on your long position.
Two situations may then occur:
– The resistance at 1.40 is finally broken. This is a losses of income for you given the fact that your first position was long, but during the period on which your position is hedge, you have not benefited from the pursuit of the upward movement. However, it allowed you to get an additional information for the pursuit of the trade: the resistance at 1.40 is broken.. You can then set new objectives for your long position.
– The resistance at 1.40 is not broken and a correction occured. The price returns to 1.3950 and you believe in the take up of the bullish movement. Then you can cut your short position opened on 1.40, take your profits and keep your long position. Result of the transaction, you won on the short position (protecting your profits on your long position at the approach of 1.40) and you are again exposed to fluctuations on your long position
Example 2 : You are long on EUR / USD since 1.3950 and the price is currently on 1.40. However, significant news have to be published on the dollar and you anticipate a volatility that could trigger your stop loss. You will therefore seek to protect your profit by hedging your position. Thus, it allows you to temporarily remove your stop loss while not undergoing the risk of exchange rate variation. In addition, it allows you to see the news published without any risk. If you see that the news is good for your first trade (long position), nothing prevents you to close your short position to take advantage of the new upward trend.
Take advantage of corrective movements
By hedging your position, you can take advantage of corrective movements while playing the trend. Your profit is therefore double, both on long and shorts positions. To use this technique, you should know well and identify turning key points that could lead to a possible corrective movement.
Example: You anticipate the rise of the EUR / USD. You took a long at 1.3950. Your objective is at 1.41. The price is currently at 1.40 and you anticipate a corrective movement on this level towards 1.3980. You will then hedge your position by taking a short position. Your scenario is realized and the price returns to 1.3980. So you take your profit on the short position by cutting your position but keep your long position and hope that your goal (1.41) will be reached. At this exact moment, the hedging of your position on 1.3980 made you win 20 pips more.
Indeed, without the hedge of your position, you had made a profit of 30 pips (1.3980 – 1.3950 on the long position)
With the hedging, your profit is of 50 pips (1.3980 – 1.3950 on the long position and 1.40 – 1.3980 on the short position).
To summarize, if a correction occurs, it is advantageous for you because you have enjoyed the correction movement. However, if the correction does not occur, you lose a part of the movement and is therefore a loss of earnings for you.
It should be noted that hedging is not allowed with all Forex brokers. Contact your broker to see if the operation is possible