Understanding hedging when dealing with forex trades

  • By Noah Schumacher

  • August 30, 2018
  • 8:32 pm BST

Hedging is a strategy in forex trading that is usually expected to allow the trader to accumulate a considerable amount of money. However, many traders don’t quite understand how it works. It pays to learn how to trade CFDs in order to make informed decisions when using certain strategies. Many traders have the misconception that a smart hedging strategy can be carried out with a small or no risk while still achieving results that are considerable.

There are many strategies that are mistakenly referred to as hedging but don’t truly fit the definition. These so-called hedging strategies minimize the risks of traders losing money and protect hedge traders against the volatility of the market, but they also expose the capital to phenomenal losses.

In fact, these strategies are not the real deal as they don’t stay within the boundaries of proper risk management. Effective risk management is vital to formulating a winning strategy. A professional CFD broker will understand the importance of risk and how it can make or break your trade. A broker has the knowledge and information available to make informed decisions.

Hedging, the real deal

Forex hedging is a practice that is commonly undertaken by large, international companies. In this instance, it is used as a means of combating the risks that are closely associated with the fluctuations in the exchange rates. Retail traders also make use of hedging strategies in order to benefit from speculation regarding currencies. For many retail forex traders, this process is not worth the rewards, and they may find that their strategy of implementing stop losses and a more conservative approach to positioning sizes is a more convenient and effective way of managing risk.

Traders who are inclined to take part in carry trade strategies sometimes hedge their carry trades by making use of currency options. The Canadian dollar, along with a number of other currencies, is strongly tied to the oil price, and it benefits from an increase in the commodity price. An increase in the price of oil is often indicative of a decline in the exchange rate between the USD and CAD as they are inversely related. This is not always the case, but it occurs frequently.

Know the difference

There are many so-called hedging strategies out there today that are far from legitimate. They present risks and should be avoided wherever possible. While the trader expects the strategies to reduce their exposure in the market and provide some sort of protective cushion, they actually have the opposite effect. Trader accounts are exposed to the possibility of enormous losses.

Many traders unknowingly refer to hedging as a combination of the martingale trading system and a grid trading system. While there are a number of different strategies of this nature, they all have the same results, obliterating the trader account. Of course, certain market conditions are conducive to these types of systems and they may yield phenomenal results in such markets, but the use of inconsistent sizing of lots poses a tremendous risk. All it takes is a trading environment that does not compliment the system and your account will essentially disappear.

A legitimate hedging trading strategy will limit the exposure of the trader to risks in the market and provide an insurance-like cushion against potential losses. Trading the market always carries a risk; that is the nature and volatility of the trade. However, limiting your decisions to ones based on knowledge, information on hand and current events will help you to minimize your risk and take advantage of opportunities to profit.