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Hedge Trading Systems for Forex

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One thing that you always should be thinking about as a forex trader is forex risk management. Managing your risk can take many forms, but one form is to do hedging.

Hedging is essentially reducing or leveling your risk by making trades that potentially cancel each other out to some degree. Some newer forex regulations have removed the ability for direct hedging with US 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 in the US it's no longer allowed.

However, there is a workaround of sorts that is not quite as clean but still exists as a hedge.

In Forex, all trading is done in pairs. There are two currencies involved with each trade. Let's say you wanted to go long on EUR/USD, but you were concerned in the short term about USD strength. You could actually go long on the USD/CHF pair as well. This would give you a long USD position to offset any losses in your EUR/USD position. The downside is that you'd have CHF exposure. This is a never ending circle, there is not really any 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 trade. Let's say you had been more concerned about your Euro exposure. In that case you could have opted to go short 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 has it 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's would be risky to have naked exposure 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 neutralizing 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'll need to remember that lot comparison between different pairs will not always break even 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're 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.

Hedging is really not a perfect science, just one that works well for lowering risk somewhat in certain situations. It should be used wisely and it should 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 minimize losses during surprises.

Did you find this article helpful? Feel free to email me at forextrading@aboutguide.com or follow me on facebook or twitter to keep up with new forex trading articles.

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