Forex Market: The commonly used alternative tool for risk management in forex trading today is hedging, is a very good tool in risk management if well applied.
A good forex trader thinks about risk management, which can take much form in the forex market, one of which is hedging.
Forex hedging is essentially reducing or levelling your risk by making trades that potentially cancel each other out to an extent.
Some new forex regulations have removed the ability for direct hedging with the United States forex traders. It used to be possible to go long and short on the same pair, in the same account. This is still possible with accounts not based in the US but it is no longer allowed in the US.
However, there is a workaround of sorts that is not quite clean, but still exists as a hedge. In forex, all trading is done in pairs. There are two currencies involved in each trade.
For example, if you want to go long on EUR/US dollars, but you were concerned in the short term about dollar strength, you can actually go long on the USD/CHF pair as well. This will give you a long USD position to offset any losses in your EUR/USD position.
The downside is that you will have Swiss Franc (CHF) exposure. This is a never-ending circle as there is no such thing as a perfect hedge. It will always be a hedge of sorts. However, you do lower your USD risk by making these trades.
The main thing to remember is that you are offsetting at least one side of your forex market trade. Let us say you have been more concerned about your euro exposure. In this case, you could have opted to go short on a pair like EUR/CHF.
The skill in creating these types of hedge trades is to look for a pair that contains the currency you want to hedge against, but is paired with another currency that has a lower volatility level.
For example, hedging with EUR/USD and EUR/JPY may not be a very good idea. The JPY has been known to be very volatile on its own. It would be risky to be exposed to it.
The ultimate way to do these hedges is to put them on during risky times and take them off when the risk lowers. For instance, during certain news releases, like employment surprises can produce large movements. It would make sense to put your hedge on before the release and take it off after.
You have to remember though that when you put on a hedge you are neutralising your profit and loss. Your gains will be as limited as your losses. This is what the US Congress thought they were protecting against when they legislated against direct hedging.
If you plan on using this type of strategy to help manage risk, you need to remember that a lot of comparison between different pairs will not always breakeven on pip value.
It always depends on the currency conversion between your currency and the currency pairs in question, and on which pair is the base pair in the pairs you are trading.
The lot size on the first pair may be 10k, but the second pair may be slightly off if you wanted to perfect the hedge, it could be a number like 10,200k to be perfectly even.
Forex market hedging is really not a perfect science, but just one that works well by lowering risk in certain situations.
It should be used wisely and not be considered a full safety net. Hedging is a great tool when used wisely, particularly when combined with other risk management techniques like good stop placement and setting targets. It can help to minimize losses during surprises.