Forex Risk Management

Hedging and Coverage: What Forex Trader’s MUST Know

If you’ve heard the word hedging or hedging mentioned and you’re not sure exactly what this is about when trading, this article can help. As is normal in my posts, an example to bring it down to earth. Imagine you have bought a car or a house. When we buy an asset of this type we usually want to protect our investment from possible accidents or situations that may occur against us.

One of the simplest ways to protect these assets is to take out an insurance policy that allows us to reduce the possible losses we might have if some unexpected situation occurs that we sometimes cannot avoid. In trading, hedging works similarly. It is simply an investment to compensate 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 using a hedging strategy is the fact that as you reduce the potential risk you also reduce potential earnings. This is because, as an insurance policy, coverage is not free. Hedging can also be achieved by opening a position in another financial asset that has a negative correlation to the vulnerable asset, that is, the initial investment we want to protect. In the case of Forex, we say that two currency pairs have a high negative correlation if the correlation is negative and above 80 generally, in this case, the pairs move in opposite directions.

For example, in the foreign exchange 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 forex correlation and how you can consult it at any time (you don’t have to do the calculation manually). It’s an important concept.

Before you continue, it’s important to know that hedging is not allowed in the United States. This is because brokers operating in that country must comply with the “no-coverage” rule known as FIFO (First in, First out. First in, first out) of the NFA (National Futures Association).

This “no cover” rule only allows for an open position on the same symbol. If, for example, we open a purchase 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. Because of this limitation, typically brokers that are regulated by NFA have international subsidiaries for their customers outside the United States.

Advantages and Disadvantages of Hedging

Like any strategy, hedging has its advantages and disadvantages. Depending on your trading system it may or may not make sense to apply it (I don’t use it, I’ll tell you later). One of the main advantages we find in having to negotiate with hedges is that they limit your losses, but as I was saying, it also erases a portion of our profits. Although it is a fairly conservative trading strategy (a priori), it allows us to have a high hit rate, although the profit/risk ratio decreases.

Hedging increases liquidity in the market because it involves the opening of new clearing 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 you to do it, bear in mind before applying it. A clear disadvantage that we must always bear in mind is that not all risks can be covered.

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 goal in different ways. Let’s look at the most common trading strategies used:

Total Coverage: As its name indicates, when we make a total coverage we keep open the same volume in long and short operations. Full-coverage allows you to block your exposure in the market, that is, raise or lower the asset in question will not affect your account. Be careful because a trade with a fixed profit and loss level could reach its stop or take profit and close (and you can keep the contrary trade open with a negative float and no coverage).

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

Correlated Coverage: The correlated hedging strategy is one of the best known in trading. Although I mentioned this strategy at the beginning of the post, let’s go a little deeper. It consists of covering an open operation with another operation 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 ups or downs. Suppose for example you decide to go short on the pair EUR/USD. Currency pairs such as 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 in AUD/USD or GBP/USD, you are more exposed in the market because of the EUR/USD short position you already have. In the case of currency pairs with a high negative correlation as the case of EUR/USD and USD/CHF, if we open a short in EUR/USD and go long in USD/CHF we would also be incurring a higher risk.

Here, we can perform a correlated coverage. What must be vital to us is always to maintain in mind the following: if the correlation is positive, to make the coverage you must trade in opposite directions (sale – purchase or purchase – sale) and if the correlation is negative you must trade in the same direction (purchase – purchase or sale – sale).

Direct Coverage: It consists of opening positions in the same currency pair. It may seem a bit confusing or pointless, I explain it better with an example (like not):

Suppose you are long in the pair EUR/USD, the position is green but still does not reach your take profit. You’re coming up with a high-impact story (for example, NFP or GDP) and you want to partially protect your earnings without closing the position. One way to protect yourself from movements due to the high volatility this news may generate is to open a short position in the same pair and when volatility decreases close the hedging position. Minimizing in this way the potential risks of the news.

Direct coverage is also often used to leverage corrective movements 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 gain in the short position while maintaining the long position.

Coverage with Futures: Hedging operations with foreign exchange futures are one of the hedging more used by the big market operators. Suppose an investment fund, based in the United States, invested in a Japanese company and generated 1 million yen in unrealized profits. Since the investment fund needs dollars instead of yen, it can buy USD/JPY futures contracts on the stock exchange for the total amount of yen it expects to receive (total coverage) or for a percentage of the total to receive (partial coverage). In this way the fund secures a fixed rate for its yen, protecting itself from the risk associated with USD/JPY torque fluctuations.

Hedging: Yes or No?

From my experience, I consider that every trader should know and know how to apply the different strategies around hedging, especially in a market as volatile as the Forex market. What we want to achieve with coverage is to minimize risks of movements against us when making an investment and at no time seeks 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 trading. There are many hedging strategies depending on the financial instrument you are operating.

Robots Using Hedging

We find a lot of systems on the Internet that may seem very attractive but that constantly make coverage by delaying losses and adding more and more positions. You can imagine how this ends. Run away from these kinds of robots. And you’ll wonder, how do you detect them? Easy, don’t buy a forex robot that you don’t know how it’s created, how it works, and you’ve spent time testing. That’s for not telling you straight away not to buy a robot to trade.

My Opinion

As you know, I do algorithmic trading and none of my systems apply hedging. They could tell you that psychologically this technique makes you not close with losses and… I ask you, why not take the loss and delay it by taking more commissions?

Doesn’t make any statistical sense in that case. Applying currency trading systems individually does not. Hedging can make sense in correlation strategies as we have seen between assets or in our stock portfolio to protect us from currency risk. If for example we buy shares in dollars but our account is in euros. I certainly think today it is an excellent tool, not for trading systems.

Forex Videos

How To Protect your Forex Trade With No Stop Loss With The Use Of Hedging!

How to save a forex trade with no stop loss with the use of hedging!

Thank you for joining this forex academy educational video.

If you are relatively new to trading, you will no doubt understand what it is like to be in a losing trade, and what it feels like losing money, and seeing your profit and loss fall. It is uncomfortable
Unfortunately, this is all a part of trading. Losing is a part of winning. The most important thing is that you win more money than you lose in order to sustain a profitable account.
One of the biggest areas that new traders fall down is a lack of understanding of leverage and a lack of understanding of money management, and risk management, all subjects for another video.
And the biggest aspect where traders lose money is because of a lack of setting a reasonable stop loss in accordance with their account size, and where quite often new traders will lose all of their money in their accounts on a single trade.
This is purely down to poor risk management and not incorporating a tight enough stop loss. But what if you have been implementing strict money management and tight stops, but simply forgot to put one on a trade which is running against you and where you are starting to worry. What are your options?

Let’s say that you identified a potential short trade, for example on this one-hour chart of the GBPUSD where you noted areas of support and resistance in a wedge formation and thought that the price action would punch through at position A, because the pair was also overbought. The technical analysis is not important.

And so let’s imaging that you have gone short in half a lot at 1.2939, and you forgot to put a stop loss for whatever reason, and the pair has shot out of the wedge formation so the upside. What are your options?

You already know the answer to this option: close the trade, take the loss, learn the lesson, and move on.

Another option would be to hedge the position, should your account size allow you to do so. This would mean that you simply buy a half a lot – the same size as your short trade, as we have done here at position B, at 1.3075. In which case, you have two open positions in the same lot size, which are effectively maintaining the losing position balance. However, this gives you an opportunity to have think about the trade and consider other options to try and salvage some of your losing funds.
The most important thing for any trader is to protect his or her profits and not how messy it might look with regard to winning and losing trades.

If you feel that the trade is running out of steam to the upside and about to reverse, you have the option of going short again at position B, in this example, in a minimum of a half of a standard lot, and in the event that the trade falls back 50% of the way to your original open position you will have a net position, which you can either close both trades, or let it run back down to the original opening trade at position A, where you will be in profit, and manage that trade should it come lower, which might mean closing trade A out and letting the second B trade run on.

Another option is to buy a standard lot at position B, in this scenario, which is double your original size, and will have the effect of reducing your loss to zero and even turning into a profitable trade should it move higher to a point being approximately 50% higher than total spread of your losing trade, less your original spread and commission.
You then have the option that if and when the trade becomes net, to close out both trades, or just close the losing trade from position A, and let the B trade run on. Use a tight stop loss at the net position to protect your profit.
All of these options are risky and with the exception of the original hedge, require tight stop losses. Again, the most critical factor is the protection of your profits, and quite often these options will help you out of a trading nightmare. Although this scenario was based on an original short trade going wrong, it applies to a long trade and any financial asset.

Forex Videos

Forex Hedging Using The Elliot Wave Setup – How To Win Trades Whatever The Outcome!

Hedging using the Elliot Wave setup

Continuing with our hedging strategy series. Today we are going to look at setting up two trades. One Which involves using the Elliott wave Theory of technical analysis, and should this prove ineffective, we will also be setting up a secondary hedging, or insurance based trade, in the event that our first trade does not go according to technical analysis.

While hedging comes in many forms and strategies, the methodology behind this type of hedging is that we want to carefully set up a trade based on tried-and-tested technical analysis, and where, in this particular case, price action may be set for a sharp reversal, but turns unexpectedly, in which case we will be able to catch the move in the opposite direction. In which case theoretically we win no matter which way price moves. Therefore this strategy works best when markets have consolidated or reached highs or lows, which seem right for reversal or continuation in price action but where the consolidation squeeze should cause a burst in volume in either direction.

Example A

Example A, Let’s quickly remind ourselves of the theory of the Elliott Wave, which consists of an impulse wave that is usually composed of 5 sub-waves that move in the same direction followed by a corrective wave composed of three subways that move against the previous trend.

Example B

Example B, Here we can see the Elliot wave in action. After a consolidation period, we can see the Elliott wave as denoted by 1 2 3 4 5 6 pattern, with higher highs and higher lows and where we would expect price action to begin to fade with our three-part full pull back as denoted by the A B C technical pattern we have drawn as an estimation onto our chart.
Therefore, if the Elliot Wave theory holds true in this case at position A, we would see a decent in price action in line with our A B C expectation, and if not, we would expect a price action continuation up to position 7 in continuation of the original upward trend.

Example D

Example D, This is the first part of our hedging strategy in which case we are going to go shorts at position A, which represents her 50% pullback between position 6 and 5, and at which point should be the beginning of the three-wave counter move in the opposite direction of the trend upwards should the Elliott wave Theory hold at this point we will capture some decent down movement, especially if this setup is used on a 15 in 30 or 60 minutes chart.
We must set our stop loss at a couple of pips above position 5, which would mean that the Elliott wave theory has not held out on this occasion, and that price could be set in a continuation upwards of the original trend. However, should position 5 on your chart be a round number and what is also called a big figure number such as 1.3400 which you might see in the USDCAD pair, or 1.300 in the EURUSD pair at the time of writing, then price action might find this as a level of resistance and fall anyway. But as the theory would be negated, we would suggest you consider this and think about exiting the trade and waiting for another Elliot Wave set up. In either case, stop losses should not be more than 20-30 pips.

Example E

Example E is our hedging strategy. In the events that the Elliott wave fails and price action continuous, we must set a buy limit order a couple of pips above the previous trade’s stop loss in order to capture the move from position 6 to position 7 and beyond. If possible, we should monitor this move closely, because as an insurance policy, we need to at the very least make the same amount of pips.i.e. 20 to 30 that we lost in the first trade.

Forex Videos

Forex Limit Order Hedging Strategy – Making Cash Hand Over Pip


Limit Order Hedging strategy

This video continues in the series showing you how you can make money by using hedging strategies to take advantage of breakouts and reversals in the market, no matter what direction. And while there are many different styles of hedging strategies, in this series, we are focussing on a simple way to maximize opportunities while increasing the chance of profitability, no matter which way the market moves and if used correctly, you will be able to utilize this in your own methodology.
While the following is risky – just like all trading, we will show you how to keep setups tight, while implementing clear and precise technical analysis that professional traders use every day in the Forex market. This strategy consists of two parts, the initial trade, and a backup trade. We have eyed an opportunity with multi-month lows for the EURCHF pair.

Example A

Example A is a monthly chart of the EURCHF pair, and we can see that the Euro is falling heavily against the Swiss franc. This is due to the flight to safety, whereby the Swiss franc is seen as a safe-haven currency during the Coronavirus pandemic.

However, the Swiss National Bank will be very unhappy about their currency being so strong and are threatening to intervene in the money markets to correct this. We can also see from this chart that we are approaching lows that have not been visited for five years. Therefore with the threat looming of the Swiss National Bank intervention, and previous reversals from these levels, we can hypothesize that although the continuing risks of the virus are still prevalent, there could be an argument for imminent price action reversal, particularly because of the current strength of the Euro and where the EURUSD is currently riding high around the 1.13 level.

Example B

Let’s take another look at this chart as in example B. While we may see some further downside in the EURCHF pair, our particular area of focus will be on the key 1.03 level. Previously price action found support at this level for several months. We are going to look at putting in a buy limit at the 1.03 level, with a tight stop loss, which, if triggered, we will also implement an immediate sell limit order to target the 1.00 key psychological trading level, which is parity.

Example C

Example C is a one-hour chart of the EURCHF pair, and our setup for the first part of this trade. We have placed a buy limit at the key 1.03 level with a tight stop loss at the 1.0270 level and a profit target of the current trading range around the 1.0550 level.

Example D

Example D, Now let’s look at our backup or insurance trade in the event that price continues to fall in the pair. We want to to set up a sell limit order at the 1.0270 level which is our previous stop-loss, and this time we need a slightly wider stop loss on this new trade at 1.0310, in case the key 1.03 level is initially targeted from our entry, and where we believe it might possibly become an area of resistance before price action reverses again and where will be looking at a target of 1.000 or parity in the pair.
On the second trade, we should be looking to implement a protective profit stop at around 1.0240 level in order to, at the very least, cover the loss from our first trade.

Forex Videos

Master Forex – Hedging Strategy Using Buy & Sell Limit Orders

Hedging strategy using buy and sell limit orders

This video is a follow on from Hedging – Making money no matter which way the market moves and Hedging Strategy Via The Ascending Pennant Chart Pattern.

The idea in this series is to incorporate a secondary backup, or insurance policy type trade, in order to maximize the possibilities of breakouts from well-known, tried, and trusted chart patterns that professional traders use. And these setups are better suited to the 15-minute, 30-minute, and 1-hour time frames, where you might expect a larger amount of pips to be made in a trending, or reversing market.

Example A

Example A is a 1-hour chart of the GBPUSD pair, but this set up works with any forex pair.

Example B

Example B shows that after an initial push higher, price action consolidates in a sideways move and this consolidation is confirmed by at least two attempts to push higher than a horizontal line of exchange rate where price action is rejected and which acts as a line of resistance and at least two pushes lower on a separate horizontal line of the exchange rate which was met with a line of support.
While this see-sawing between the resistance and support levels may continue for some time, one thing is for sure, that eventually, price action will either break to downside or break to the upside.

Example C

Now let’s look at Example C. This is where we will set up our first limit order. Firstly, price action appears to be fading to our support line, as defined by the green line. This fading of price action means that we are more likely, at this point, to see a breach of our support line and a continuation in price action in a downwards direction.
Therefore we have placed a sell limit order a couple of pips below the support line with a stop loss a couple of pips above the resistance line.

Example D

Now we must turn to example D, which is our secondary backup buy limit order, which we believe would be a good insurance policy should price action break the resistance line and move in an upward direction.
In this situation, we simply set our buy limit order a couple of pips above the line of resistance with a stop loss a couple of pips below the area of support.

The idea regarding our hedging strategy is to prime everything in readiness for where we believe the price action will go due to our technical analysis and also to set up a secondary trade in the reverse direction as a backup or insurance policy in case price action reverses in the opposite to the direction where we believe price action will go.
Obviously, it is possible that both trades could be executed and therefore we would advise that you keep an eye on the trade and should both trades be executed and where one triggers a stop loss, the profit target from the secondary trade should be at the very least the amount that was stopped out on the first trade, in order not to adversely affect your profit and loss.