18/05/2012
In the simplest explanation, Hedging means taking steps to reduce the risk of losing in a trade. This way, even if things go in the opposite direction to what you predicted, you will still be protected or will lose less.
Read this article or google if you are new to the word.
In Fx trading, you can hedge the risk of your trade by opening a trade in the opposite direction. Therefore, if you start to lose from the trade you opened you will automatically start to profit from the hedging trade you opened in the opposite direction.
Lets consider an example:
You think the market for ABC/XYZ is going down so decide to sell ABC/XYZ.
Let’s consider two possible scenarios with and without hedging.
Original trade – Sell ABC/XYZ Pair At The Rate Of 1.1234
Hedging trade – Buy ABC/XYZ Pair At The Rate Of 1.1234
Scenario 1:
The market behaves opposite to what you speculated (predicted) and goes up making you a loss.
Let’s see how you will lose with and without hedging:
So, with hedging you have managed to eliminate your loss. Don’t jump into conclusions till we consider the second scenario.
Scenario 2:
The market behaves as you speculated (predicted) and goes down making you a profit.
Let’s see how you will lose with and without hedging:
As you can see hedging has justified your profit just like it did for your loss.
So this is not the best way if you are into making money. The above mentioned strategy is the Risk-Eliminating strategy which eliminates your risk of losing money. But in real world this is not very useful.
The Risk Reducing Strategy
This is the interesting part of hedging. This is where we use hedging to minimize our risks and use it to make us more profits under best case scenario (where everything goes as we predicted) and less profits otherwise.
How to do this?
Instead of blindly creating an equally opposite hedge trade, we consider market trends and optimize the hedge trade by changing the size, start position, Take Profit and Stop Loss limits. Perfectly conducted, this method can double or triple you profit and can make more money in a situation where you could have actually lost if you did not use hedging.
Lets consider an example:
During early days of May, 2012 Euro zone has been having big problems due to financial instability of Greece, Spain and some other countries. As a result the Euro has been losing its value continuously.
This could sound like a great opportunity to make money by selling EUR/USD but how can you say that the Euro will continue to drop? When will it stop? What if it turns back suddenly?
This is a perfect place to occupy your hedging skills.
I will explain the strategy I used as an example:
Lets assume the current value for EUR/USD is 1.2690
- The continuous fall of the pair indicates to me that this should fall more before things reverse. But I have no idea how far this fall will continue.
- Eevn though EUR/USD is going down at the moment, it is a universal priciple that any market should settle over time. So The chances are very high that at a particular time the market will reverse and head back up.
- Considering above two facts, I can come to following openion:
- The market has a probability to fall even further down and it is almost definite that big-heads in Eurozone will do everything they can to settle their issues so the market will slow down and return at some point.
- In other words Fall of rate is short term and less probable and the Rise of it is long term and Highly probable.
- Considering these factors I assign a weight to these movements. The fall will have a probability of about 30% and the Rise back is 70% probable.
- Therefore I will invest 30% of the amount I wish to invest on the downward movement and 70% on the upward.
- So I will be making two trades one hoping the rate would fall and another to cover the rise.
When to open these trades?
The Sell Position
Since the current market movement is downwards, I’d open the Sell position at the current rate (1.2690)
Assume I decide to invest 30 dollars for the Sell (Falling) position and 70 for the Buy (Returning) Position
As the fall could be reversed and any time, I’d use a short take profit limit (about 20%) so I will have more chance to make some money before the rate reverse. If the rate seem to be dropping even more then I’d adjust the TP limit later.
I will set the the stop loss to as much as I have invested on the selling position so if the market return before reaching my take profit, The maximum I will lose will be the amount I invested for the Sell position (30 dollars).
Following are the Limits for the Sell Position:
Opening Rate : 1.2690
The Take Profit Rate : 1.2670
Stop Loss Rate : 1.2790
The Buy Position
As the market is going down at the moment it will be a waste to open the Buy position at the same rate as the Sell position. Instead I will place an order to Buy EUR/USD at the rate of 1.2710 so if the market returns and pass this mark this trade will start to hedge my losses of the Sell Position.
Since I am investing more on the buy position, I will get wider range for this trade. So I will be able to get a stop loss value with will be way below the Take Profit value of my sell position and a value that I am confident will not be reached by the current fall.
My Take profit for the Buy position will be a high rate (about 50%) because I am confident the market will return to its original values sooner or later.
So the Limits for the Buy Position:
Opening Rate: 1.2710
Take Profit Rate : 1.3000
Stop Loss: 1.2400
Following diagram illustrates my two positions:
Now let’s consider several scenarios that could happen:
Scenario 1 Best case scenario
The rate will continue to fall and turns back at 1.2500 and over a week reaches 1.300
Outcome:
I will earn the profit from the sell position at 1.2670 and will earn from the buy position at 1.3000 this will make a significant profit overall 
Scenario 2 Not the best scenario
The fall returns before reaching the take profit of the sell position and goes above its Stop loss making a loss of 30 dollars. However, this movement will also make a profit from the Buy position. Since I invested more on the buy position, my profit will be greater than my loss making an overall profit
Scenario 3 A bad scenario
The market falls below the take profit of the sell position making me some money and continues to fall unexpectedly even below the Stop loss limit of the But position. Even though this would make me a profit from the sell, the loss made for me from the Buy position will be greater because I have invested more on the buy position. This will be an overall loss 
but still the loss is hedged (minimized) by the profit I made from the sell position.
Scenario 4 The Worst Case Scenario
The market turns around unexpectedly and goes above stop loss level of the selling position but returns to fall back before reaching the Take profit of the buy position. then continues to fall below the stop loss of the buy position. This will make the worst loss from two trades
In A Nutshell
As you can see hedging can be used effectively to increase your profits and reduce your losses. The key is creating a strategy that will not go in the worst possible path. This is not very difficult when you consider news and graphs. Because by looking at previous data you can decide more stable stop-loss levels that are not easily breached.
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