Forex traders sometimes use a technique known as Hedging when trading Forex. It is typically used for portfolio or account protection, and most people don’t know or understand how hedging works. While you may have heard the term Hedging, it may or may not be a trading strategy that you want to adopt into your bag of tricks. But even if you are a beginner, you can learn what hedging is, how it works, and what hedging techniques you can use to help protect yourself, should you choose to do so. How does this apply to Forex robots? Well, some creators of Forex Robots program in Hedging capabilities, but you have to use a broker that allows hedging, and many don’t.
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What Is Hedging?
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Put simply, Hedging is the practice of taking long and short positions in the same currency pair in the same account. While at first glance, this may seem ridiculous (and I tend to agree that Hedging is a poor practice), there are valid arguments for Hedging in any investment, even Forex Trading. Here is an example of hedging a forex trade:
You place two orders for EUR/USD. One is a long position (profiting when the market goes up) and the other is a short position (profiting when the market goes down). So here, in reality, you are “flat”, meaning you have no position. Whether the market goes up or down, your net profit will be $0 (less the spreads you will pay on BOTH transactions). So why would anybody do this? Primarily to “offset” their potential losses.
Say instead you are long EUR/USD. The market turns against you and drops 50 pips ($500 on a standard account). Instead of closing out your position and taking the loss, you open a short order on EUR/USD. Now the market continues to move down. As it does, the profits on the short position offset continued losses on the long position. So it moves down another 200 pips. The market reverses, and you exit your long position (for a 200 pip temporary profit of $2000). Now if the market continues to move up, the loss you were floating on the long position is reduced. If you exit your long position at that 50 pip loss point, now instead of losing $500, you have taken a net profit of $1500 ($2000 � $500). Sounds great, doesn’t it?
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The Downside of Hedging
Every hedge has at least ONE cost. Usually more. The first cost in hedging is that you have double your transaction fees (that is, you pay the spreads twice, once on the long and once on the short position). But a few pips is worth it if you manage to prevent taking a 50 pip loss (or more). But the big problem is the additional costs:
What happens if the market turns just after you place that hedge order? In our example above, as that $500 loss is reduced due to the market moving up, you are adding a loss from the short position hedge you just placed, thus retaining that $500 loss. Or if you close out the hedge for that temporary profit, but the market continues moving against your original position, now you have nothing to offset those losses anymore.
Hedging is very difficult, especially for beginners, and even more so for Forex Robots and Automated Trading Systems. Most Forex Robots and Automated Trading Systems have a hard enough time (actually, almost impossible) predicting market movements for their “normal” trades, much less trying to hedge the account properly.
Hedging Forex Trades In The US
On May 15th, 2009, the National Futures Association (NFA) introduced a new rule preventing FDM’s from allowing customers to hedge their trades. This means that no US broker will allow you to hedge, thus any Forex Robot or Automated Trading System that utilizes hedging will NOT work with a US broker. Excerpts from the NFA ruling:
NFA is concerned that customers employing this strategy do not understand either the lack of economic benefit or the financial costs involved.
…many of the FDMs admit that customers receive no financial benefit by carrying opposite positions…
NFA has two major concerns about this strategy. First, it essentially eliminates any opportunity to profit on the transaction. Second, it increases the customer’s financial costs in several ways. One way it increases costs is by doubling the expense of entering and exiting the transactions. In the on-exchange markets, a customer who carries opposite positions will normally pay twice the commissions. Similarly, a forex customer will pay the entire spread twice (buying at the high end of the spread and selling at the low end) rather than paying half on entry and half on exit. Additionally, the customer pays carrying charges that always exceed the funds it receives. In a normal transaction, a customer receives “interest” on the long position and pays “interest” on the short position. Since the two transactions are mirror images, you would expect the receipts and payments to zero out. In practice, however, the amount a customer receives on a long position is always less than the amount a customer pays on a short position. Since these transfers occur daily when the positions roll over, the loss increases continually over time.
What Hedging Means To You
If you don’t practice hedging during your trading, absolutely nothing. But if you hedge, or if you want to use a Forex Robot or Automated Trading System that uses hedging, then it means quite a bit. It means you’ll have to use a Non-US and potentially Non-regulated Forex Broker (which can be very dangerous if you don’t choose a good broker). It also means your Forex Robot or Automated Trading System will cost you more money, in the form of additional spreads, since it will open up trades in both directions at times. And if you’re really lucky, maybe it will open them at the right times, and close them at the right times, to prevent you from losing TOO much money. But they aren’t usually very good at making good trades in the first place, much less hedging your account.
And remember, the primary goal of hedging is to minimize your losses, not to make profits. Personally, I trust my money management rules, my risk management rules, and my trading methods a whole lot more than hedging.
Hedging during Forex trading might help you, but it could certainly be disastrous as well.