What Is Hedging? And How To Hedge Trades

What Is Hedging And How To Hedge Trades

Hedging is a form of risk management that involves taking an opposite trade in the same instrument or a similar asset.

The goal of a hedge is to offset or limit potential losses.

Just as you can insure assets against potential damage, you can think of hedging as a type of trade insurance.

How does it limit risk?

As mentioned our objective when hedging is to open a new position, contrary to an already existing trade.

If the original position makes a profit during this period, the new trade will lose.

If the new position makes a profit, the original trade will lose.

Either way, the hedge trade balances any profit or loss, removing any risk.

Hedging strategies

  1. Trade the exact instrument in the opposing direction to your bias. Say your goal is to hedge a 5 lot EURUSD buy position, the easiest option is to sell 5 lots of EURUSD.
  2. Hedge using correlated instruments. For example, you can use AUDUSD to hedge an NZDUSD trade because of the strong correlation.
  3. Use derivatives such as options or futures. Derivates are contracts based on an underlying asset e.g. currencies, stocks, indices, and commodities. Because the underlying asset determines the value of the contract, derivates are commonly used for hedging.
  4. Maybe you don’t want to hedge directly because it decreases profit potential. Instead, you can use diversification in various instruments, markets, or strategies to reduce risk and “hedge” against trades.

 

The first option is a “perfect” hedge because the trades cancel one another out. The other options also limit risk, but the monetary gain or loss is not guaranteed to balance out perfectly.

Advantages of hedging

  • Reduces risk.
  • Smooths out returns.
  • Prevents large drawdowns.

Disadvantages of hedging

  • Costs money (transaction costs).
  • Reduced profit potential.
  • Have to manage more positions which can become overwhelming.

Conclusion

Hedging is not for everyone. You need to consider if less risk is worth the potential loss of profit.

The best way to find out what works best is to backtest your strategy, study the results, and pick the equity curve that appeals to you most.

May the market be with you.

Hedging FAQ

Hedging is a form of risk management that involves taking an opposite trade in the same instrument or a similar asset to offset/ limit potential losses.

  1. Trade precisely the same instrument but in the opposing direction.
  2. Use correlated instruments to limit risk.
  3. Open a derivatives position based on the underlying asset.

It depends on the trader and strategy, but here are some pros:

  • Reduces risk.
  • Smooths out returns.
  • Prevents large drawdowns.

The cons of hedging are:

  • Costs money (transaction costs).
  • Reduced profit potential.
  • Have to manage more positions which can become overwhelming.

 

But it is an effective way to limit losses, so you must consider if the risk management benefit is worth it.

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Guy Seynaeve

Guy Seynaeve

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