Widely-known as the act of strategically opening additional positions to protect against adverse market movements, hedging is one of the methods used by professional traders to manage their risk.
We live in a period of great economic, geopolitical, and financial uncertainty, meaning the need for holding the risk under control should be one of our top priorities. If last time we’ve talked about how to trade forex with geopolitical risk rising, now we would provide some simple methods to hedge your positions.
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Direct hedging strategy
This is one of the simplest ways to hedge an open position and requires you to open another trade in the opposite direction. Opening both opposing trades at once will mean the net profit of the direct hedge is zero, but most of the professionals choose to use this method when the price action encounters technical resistance or support.
Let’s assume you are short EURUSD, your trade is in profit since a few days ago, but all of a sudden you see the price starting to move on the upside. Opening a buy order when the price shows signs of change, will lock the profit from the initial trade + allowing you to profit from a counter-trend move if the market will resume on the downside after a correction.
Multiple currency hedging
Our second hedging strategy involves two different currency pairs that have a strong positive correlation. GBPUSD and EURUSD are two great examples, especially when you trade based on the US dollar movement. This strategy is also very simple and involves opening a buy order on the first pair and a sell order on the second, or vice versa.
You must take into account some risk management parameters, however. As usual, we are professional traders and we use stop loss for each of our trades. Not only that, but the risk/reward ratio should be at least 2/1 (for example, both trades have 40 pips stop loss and 80 pips take profit). If the correlation between both pairs remains relatively stable, one trade will end up with a loss and the other with a profit. The main downside of this hedging strategy is that correlation can vary by a wide margin, depending on the market conditions.
Summary
The bottom line is that using a hedging strategy can help to lock profits when the uncertainty of the future price direction rises. Our advice is to use this type of protection when you have a winning trade, or when you trade the news with two opposite trades.