What is Hedging ? Learn why trader use hedging

You all may have this question “what is hedging” if you are new to the trading field. Let us clarify all your questions and answer. “Traders use hedging if they are not sure about the future course of the market and if they anticipate massive swings on either side of their trade position due to unpredictable news outcomes.

In the Forex market, first, you need to speculate the news. After all, it can build a trend for you to ride and kill the trend you are already having fun with money. And because no one knows what the US President will say or how much interest FED will decide and all other news alike. Other news has different impacts on their relative currencies. There is one thing in common: they are unpredictable.

When trading in forex, there is a need for understanding what hedging is and how it can help you trade profitably. A hedging strategy is designed to reduce the risk of an investment by creating a shield against price fluctuations. The purpose of a hedge is to offset any potential losses or gains which another partner investment could incur. A hedging strategy in forex trading is very similar to that of an insurance policy but on a much larger scale.

What is hedging

What is the hedging amount you should engage in

Hedging in forex is the act of positioning a portfolio of assets or investments to reduce the risk of price fluctuations. If you are new to forex hedging, you should know that it is not the same as “hedging your bets” regarding price movements. Instead, it is the act of “taking” or “laying off” some of your risks to reduce the risk of price fluctuations. Some of the factors that determine the amount of hedging you should engage in include:

The time over which you will hedge.

You can hedge for any time frame; however, shorter positions have less influence on price movements than longer ones. Longer positions are more exposed to price extremes because they tend to be “shorter” in duration. Hedging can be either short-term (i.e., two weeks) or long-term (i.e., one month).

The volatility of the market that you are planning to hedge.

In a bear market, hedging would be counter-intuitive because price tends to rise in a bull market because of increased investor confidence. It would make more sense to remain in a longer position and let the prices of assets increase naturally over time. However, this is not always possible, especially in the forex market, where the price is unpredictable.

The size of the positions you intend to hedge. 

If you plan to hedge long positions, you are taking on greater risk. While this may ensure higher returns during bull markets, it can also lead to loss during bear markets because of the lower capital available to invest in those positions. Hedging short positions allows you to adjust your risk level without changing your total returns.

The size of the entry position in your hedging strategy.

This is important because it determines how much money you can lose in any given trade. For example, you can hedge a short position with a long position, but you can only do so if you have a sizable amount of cash on hand. On the other hand, if you hedge with a small position, you are taking on less risk, but you do not have as much capital available.

News Hedging to save and make a profit

We will then explain two essential parts of the hedging concept: how you can use the news to make or save profit. Let’s dive deep into the first part, which is News Hedging.

A. News Hedging to make profits 

To do news hedging for profits, you will need to be prepared in advance. The various steps are-

i. Decide what news to hedge

To decide on what news to hedge, hop on to foraxfactory.com and there you’ll find date wise news release schedules. Get to “today’s date”. There you’ll find three colors of folders.

  •  Yellow: Least impact news.
  •  Orange: Medium-Impact news
  •  Red: Critical and high impact news

Our motto here is to look for news that has enough impact on that particular country’s economy and gives the current direction of any nation’s economy or covers specific events in a country. Means is it growing forward of falling behind. 

ii. Decide the pairs you want to work with

Now, as you have checked what news will release on a particular day, decide what pairs will be most impacted and what you should be choosing. Choose the currency pairs which are associated with the news marked in red. Anyways, choose a currency pair that displays movement or sitting at reliable support or resistance levels.

E.g., let’s say the news may release about any of the major currencies, and every folder you see is yellow. What do you you do then?

Those who are picking news to trade/hedge are mostly wrong. And those who are staying away are mostly right. Primarily because in trading, nothing is black and white. Anything can happen anytime. Just like Yellow, we also don’t advice to trade brown folders. Now you are left with red folders. These are the most impactful news releases. You can see what currency that particular news is going to affect and what source that news is coming from. (Source are not the website they are published on, but the institute releasing them like major banks like ECB, BOJ, BOC, FRB, MPC. 

iii. trade setup 

Now it’s time to laying down your plan. It would be best to decide the news and the currency pair you want to trade by now.

Now, be attentive. This is going to get messy.

To hedge news, you are always going to – 

 – Put two trades

 – With the same lot sizes, and 

 – Around the same levels.

Trade setup steps one – Decide on your trades’ current levels and make your best assumptions. Based on the current levels without taking the news into account. If you are sophisticated enough, you can also draw both positive and negative projections. Do this not before half or one hour ago.

Trade setup steps two – take news into account, and there you’ll see projections. 

Trade setup steps three – with a risk-reward ratio ranging between 1:a.5 to 1:2.5 and setup two opposite trades (buy and sell) with the current level. 

iv. Impact Analysis

When you have set up everything, trust yourself and don’t disturb stuff in between. News events generally give rise to trends. In some cases, significant movements can happen even in one hour before range *CAD fluctuation image*, that’s why I have suggested to set up trade half to an hour beforehand.

Now when the news event has happened, you may see movement. So let’s say that particular news was positive and the market was bullish; your sell position will be SL while the Buy trade will be TP. The same thing will happen if there was a negative impact or a bearish trend. Your buy trade will be SL, and the sell trade will be TP.

V. Rinse and repeat

Don’t let go of this trade just like that. Take notes and improve levels and analysis in the next trades. 

B. News Hedging for saving your profits 

News hedging is the art and science of keeping your already made profits safe. This technique is more helpful for long term investors who have traded already running in profits. And this type of hedging is like an insurance for your earnings.

Let’s dive deeper

i. Decide news to hedge

All the technicals for deciding news to hedge for saving your profits will be the same as I mentioned in the “Decide the news” in the “hedging for-profit” section above. With a slight difference. This difference is to choose news impacting pairs you already in. E.g., Let’s say you are holding a sell position for GBP/JPY. Keep an eye on every news involving Either GBP or JPY.

ii. Trade setup

As we have taken an example of GBP/JPY to sell a position, you have already made 1000 pips. You feel that certain news can return the trend you are riding some hiccups, even reverse it.

iii. Impact Analysis

The news you were trying to hedge may or may not affect the trend. So if the trend continues, your hold position will be open, and your new trade will hit SL., or if the trend is reversing, you can manually close your hold position, and this second trade covers your profit.

Conclusion

What is hedging is a highly effective way to reduce risk by allowing you to take advantage of prices that may fall or rise. You can use hedging strategies throughout the market cycle, but you should be significantly involved when volatility is high. When there is a large amount of consolidation in the market, a security price will likely decrease for a time and then increase again. When you hedge, you purchase securities that you believe will increase in price, and then you sell them when the price increases, thus effectively shielding you from any negative impact of that price increase.

As with all investing types, you need to carefully assess your risk tolerance and overall investment goals before hedging. Although hedging can protect you against certain losses, it is not sure. If you do not protect yourself, you could end up with even greater losses. Before you start hedging, you should get some basic financial information to compare your hedging strategies with other investments and determine whether they are right for you.