Forex traders buy or sell a currency pair for various reasons. This comes either because of their technical analysis, or of interpreting an economic news. Or, simply they don’t like a currency pair and they don’t want to own it.
For example, when the Euro was introduced, a lot of skeptics gave no chances to the European project. After all, history was on their side: never a monetary union survived the test of time.
Retail traders face some other challenges. They are short-term traders. This means they will scalp their way into a trade, trying to get as fast as possible out of a trade with as big a win as the market allows.
At best, they are swing traders. But no investors. Having said that, at times, the market forces them to make difficult choices.
What do you do, as a retail trader, when you trade the same strategy on different timeframes? One timeframe may give a long signal, another one a sell signal…on the same currency pair. The answer is hedging.
Hedging in Forex Trading
Hedging means going long and short the same currency pair on the same account. If the volume is the same, the account is fully hedged.
For example, if you buy one lot EURUSD and sell one lot EURUSD, the result is a fully hedged account. From this moment on, the balance of your trading account is frozen.
However, the equity will change. One of your trades will end up costing you some money. This cost is the negative swap paid daily.
These days, being short EURUSD pays a positive swap, while being long costs you a negative swap. As a rule of thumb, the negative swap is always bigger. Otherwise, everyone will hedge and make money on the interest rate differential. This in not happening in the real world.
So, the idea is to temporary hedge your account when required. You can be short EURUSD on the hourly chart and long on the four-hour time frame. After a while, the take profit or stop loss on the hourly trade will be reached and the trade closed. The hedge functioned.
If the volume of the two opposite trades differs, the account is partially hedged. In other words, the balance will change based on the difference in volume.
Partial hedging takes place for various reasons. One would be to release some margin. You see, when you hedge a position, fully or partially, some of the initial margin blocked will be released.
Therefore, you can use it for other trades. People that must respect strict money management rules sometimes use this small trick.
Hedging in the United States
Due to strict regulations, in the United States, one cannot hedge in a trading account. That’s the regulation.
However, this can be “bent”. Either open multiple accounts with the same broker or a different account with some other broker and follow the same principle.
Trading Correlated Pairs
The best way to hedge a trading account or a portfolio, as a matter of fact, is to trade correlated pairs.
Some correlations in the Forex market are simply amazing. Take the EURUSD and USDCHF pairs. When the EURCHF was pegged to the 1.20 level, the two majors moved in opposite ways, almost identical.
Even now that the SNB (Swiss National Bank) dropped the peg, there’s still a strong, inverse, correlation between the two. Therefore, one can avoid the limitations in a trading account and can hedge a trade via a correlated pair.
For example, if you are long EURUSD, instead of selling EURUSD you can simply buy USDCHF. The result is the equivalent of hedging your position.
Other correlations work too: gold and AUDUSD, USDCAD and oil, USDJPY and Dow Jones…and the list can go on.
All in all, hedging is a great money management tool. Even though in some parts of the world it is forbidden, smart traders know other ways to benefit from it.
Its advantages cannot be ignored. If anything, it represents just another way to diversify the resources in a trading account and to protect it ahead of unexpected swings.
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