The forex market has its ups and downs. Thus, only those who learn the art of mitigating the risks can survive. Hedging is a popular approach to mitigate risks in forex. Even among newcomers, what is hedging in forex remains a popular topic of discussion.
Know about hedging in forex
If one’s existing position has turned against them or they realize that it is going to become unfavourable, one can open an offsetting position to cover the current position temporarily. This process is called hedging.
Hedging can either be performed on the same pair currency or a pair that has a high correlation.
There are two types of forex accounts – the hedging account allows the user to open an offsetting position on the same currency pair or asset. In contrast, a netting account does not allow it. If a user tries to perform both – long and short on the same asset in a netting account, only the latest action stands. The previous position is closed and the user loses it.
Due to this, many brokers outside the USA do not even offer netting accounts. As netting accounts are mandated in the USA, they are increasingly found.
Understanding hedging – an analogy
To further understand how hedging works, let us consider this analogy.
Consider a consumer who wants to order a pair of jeans from an e-commerce store. However, there is a slight confusion regarding the size – the consumer doesn’t know whether size S or M is the perfect fit. If the consumer ends up buying the wrong size, the store doesn’t accept returns after the product has been tried. There is a risk of paying and losing one’s money on an ill-fitting piece of clothing.
To mitigate this risk, the consumer orders two pairs of jeans – one in size S and the other in size M. Once the products are delivered, the consumer can keep the size that fits and return the other pair. This is what happens in hedging too – the user tries to minimize the potential losses without losing much on the returns.
Types of hedging
There are two types of hedging – direct and correlated. Given below is a detailed explanation of both.
In direct hedging, the user keeps the long and short position open on the same currency pair. Having a hedging account is a must to apply this strategy. Thus, forex traders in the USA cannot apply direct hedging.
In correlated hedging, the trader chooses an offsetting position on another currency pair that has a high correlation. Due to the involvement of two different currency pairs, traders with any type of forex account can employ this strategy.
The ultimate goal
When one compares the two methods, one can see that direct hedging is simple. However, there is a risk of setting off a series of bad decisions. Through experience, one can increase returns through direct hedging. For people who trade over different time zones, direct hedging is an effective strategy. Correlated hedging is relatively more advanced, but it is also the more effective strategy of the two.
