What is Hedging or Coverage in Forex?

If you have heard the word mentioned hedge or coverage and you are not clear about what exactly this is about when we trade, this article can help you.

As is normal in my post, an example to bring it down to earth. Imagine that you have bought a car or a house. When we buy an asset of this type, we normally want to protect our investment from possible accidents or situations that may occur against us.

One of the easiest ways to protect these assets is by taking out an insurance policy that allows us to reduce the possible losses that we could have if an unexpected situation occurs that sometimes we cannot avoid. In trading, hedging works in a similar way.

It is simply a investment to offset or protect our funds, reducing the risk of price movements against us. In this way and simply put, investors or traders use hedging to reduce and control their risk exposure.

A very important aspect when you use a hedging strategy lies in the fact that as you reduce potential risk you also reduce potential profit. This is because, like an insurance policy, coverage is not free.

The hedge It can also be achieved by opening a position in another financial asset that has a negative correlation with respect to the vulnerable asset, that is, the initial investment that we wish to protect. In the case of Forex, we say that two currency pairs have a high negative correlation if the correlation is negative and generally above 80, in this case the pairs move in opposite directions.

For example, in the forex market, the pairs with a high negative correlation are usually the EUR/USD pair and the USD/CHF pair.

Anyway, I leave you a complete article that I wrote about correlation in forex and how you can consult it at each moment of time (you do not have to do the calculation manually). It is an important concept.

Before continuing, it is important that you know that hedging not allowed in the United States. This is because brokers operating in that country must comply with the “non-coverage” rule known as FIFO (First in, First out. First in, first out) of the NFA (National Futures Association). .

This “no hedging” rule only allows you to have one position open on the same symbol. If, for example, we open a long position on an instrument and then open a short on the same instrument with the same volume, the initial position is closed because one order cancels the other.

Due to this limitation, brokers that are regulated by the NFA usually have international affiliates for their clients outside of the United States.

1. Advantages and Disadvantages of Hedging

Like any strategy, hedging has its advantages and disadvantages. Depending on your trading system, it may make sense to apply it or not (I don’t use it, I’ll tell you later).

The main advantage of hedging is that it limits losses, but as I was saying, it also erases a portion of our earnings.

Although it is a fairly conservative trading strategy (a priori), it allows us to have a high success rate, although the profit/risk ratio decreases.

Hedging increases liquidity in the market because it implies the opening of new compensation operations. However, this represents a disadvantage as a trader because you will pay more commissions.

Although we can do it on almost any platform, some brokers do not allow it, keep this in mind before applying it.

A clear disadvantage that we must always keep in mind is that not all risks can be covered.

2. Types of Hedging strategies in Forex

The types of hedging strategies are varied and although they all seek to reduce risks and limit losses, each of these strategies can achieve its objective in different ways.

Let’s see the most common strategies used while trading:

2.1. Total coverage

As its name indicates, when we carry out a total coverage, we keep the same volume in long and short trades.

A full coverage allows you to block your exposure in the market, that is, raising or lowering the asset in question will not affect your account. Beware that a trade with a set profit and loss level could hit your stop or take profit and be closed (and you can keep the opposite trade open with a negative float and no hedge).

2..2. Partial Coverage

With a partial hedging strategy, you have open long and short positions, but with different volumes. Here there is already risk (the difference between the volume of one and another position of the same asset that you have opened.

23. Correlated Coverage

The correlated hedging strategy is one of the best known in trading. Although I already mentioned this strategy at the beginning of the post, let’s go a little deeper.

Consists in hedge an open trade with another trade in a correlated currency pair. The correlation between both currency pairs or assets can be positive or negative.

In Forex, an alternative is to trade “strong” currencies against “weak” currencies and thus maintain less exposure with strong rises or falls. Suppose for example that you decide to go short the EUR/USD pair. Currency pairs like AUD/USD and GBP/USD have a high positive correlation with EUR/USD, so their price is likely to fall as well.

If you open another short on AUD/USD or GBP/USD, you are more exposed to the market because of the short EUR/USD position you already have.

In the case of highly negatively correlated currency pairs such as EUR/USD and USD/CHF, if we short EUR/USD and go long USD/CHF we would also be incurring higher risk.

Here we can make a correlated coverage. The important thing is to keep the following in mind: if the correlation is positive, to hedge you must trade in opposite directions (sell – buy or buy – sell) and if the correlation is negative you must trade in the same direction (buy – buy). or sale – sale).

2.4. Direct Coverage

Consists in open positions in the same currency pair. It may seem a bit confusing or meaningless, I’ll explain it better with an example (of course):

Suppose you are long on the EUR/USD pair, the position is in the green but you have not yet reached your take profit. The publication of a high-impact news (for example the NFP or the GDP) is coming up and you want to partially protect your profits without closing the position. One way to protect yourself from movements due to the high volatility that this news may generate is to open a short position in the same pair and when the volatility decreases, close the hedge position. Thus minimizing the potential risks of the news.

Direct coverage is also often used to take advantage of corrective moves in a trend. Anticipating a possible price correction in an uptrend, we can cover a long position by opening a short position. If the correction does occur, we take profit on the short position while holding the long position.

2.5. Futures Hedging

Hedging operations with currency futures are one of the hedging most used by large market operators.

Suppose a mutual fund, based in the United States, invested in a Japanese company and has generated 1 million yen in unrealized profit. Because the mutual fund needs dollars instead of yen, you can buy USD/JPY futures contracts on the exchange for the full amount of yen you expect to receive (full hedge) or for a percentage of the total to be received (partial hedge). . In this way, the fund ensures a fixed rate for its yen, protecting itself from the risk associated with fluctuations in the USD/JPY pair.

3. Hedging yes or no?

From my experience, I believe that every trader must know and know how to apply the different strategies around hedging, especially in a market as volatile as the Forex market.

The main objective of hedging is to minimize the risks of movements against us when making an investment and at no time does it seek to maximize potential profits, so we can consider it a purely defensive strategy.

It allows us to manage our positions in a calmer way, reducing the stress of the psychological factor when we trade. There are many hedging strategies depending on the financial instrument you are trading.

4. Robots that use Hedging

There are many systems on the Internet that may seem very attractive but they constantly make r coverage.delaying losses and adding more and more positions. You can imagine how this ends.

Run away from these types of robots. And you will wonder, how to detect them? Easy, do not buy any forex robot that you do not know how it is created, how it works and you have spent time testing. That for not telling you directly that do not buy a robot to trade.

5. My opinion

As you know, I do algorithmic trading and none of my systems are hedged. They could tell you that psychologically this technique prevents you from closing with losses and…

I ask you, why not take the loss and delay it by assuming more commissions?

It doesn’t make any statistical sense in that case. Applying currency trading systems individually no. Hedging can make sense in correlation strategies as we have seen between assets or in our stock portfolio to protect ourselves from currency risk. If, for example, we buy shares in dollars but our account is in euros. At these specific moments it seems to me a good tool, not for trading systems.

What is your experience with hedging? Do you apply it? I read you in comments!

Thank you for reading!

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