How to Use Hedging in FOREX Trading

Risk management is a key to Forex success.
i Creatas/Creatas/Getty Images

In the world of investing, hedging refers to making multiple investments with inverse price-action relationships. If one investment weakens, another will strengthen at the same time, limiting the total negative impact that any single investment can have on a portfolio. Although hedging applies most directly to stock trading or investing in general, it is possible to put the concept of hedging into practice when trading currencies in the Forex market. Understanding how to use the concept of hedging in Forex trading can give you an edge in the market and increase your probability of earning consistent returns.

Forex Hedging Basics

Hedging is primarily a risk-management technique, allowing investors to limit the amount of money they can lose in a given timeframe. However, essentially placing bets against each other in the market can limit your profit potential at the same time. The key to making hedging work is to earn greater gains from strengthening assets than you lose from a corresponding hedge. Hedging in Forex has less to do with buying complimentary assets and more to do with placing complimentary trade orders. In many cases, two pending orders can hedge against each other, or partial orders can hedge against losses in a single trade.

Pending Breakout Orders

Pending buy and sell orders can be used to place a hedged bet outside of a consolidation zone, in which trends level off and markets generally move horizontally. Since Forex markets are constantly moving between periods of expansion and contraction, an expansion is guaranteed to follow a contraction eventually. Because of this, traders can place a pending buy order above current resistance and a pending sell below current support. Once the market breaks out of support or resistance, it is likely to continue moving in that direction for at least a short while. Hedging pending orders around a consolidation zone allows you to get in the market at an opportune time, no matter which way the price moves. Once one of the orders is triggered, it is necessary to cancel the other pending order since the trend has changed.

Scaling In or Out

Forex traders have the ability to trade virtually any amount of currency at once, allowing them to break a single order into multiple orders while still putting the same amount of money in the market. If you wished to trade $200,000, for example, you could break that trade into one order to buy $150,000 and another order to buy $50,000. This technique can be used to hedge portions of a single order against itself to capture profits or limit losses. Alternatively, you can close out portions of a single position to capture some profit while keeping the rest of the trade on the table exposed to risk.

Placing Multiple Orders

Although pending orders are preferable, placing concurrent orders in opposite directions can act as a hedge as well. If the two positions are of equal size, one position should make profit at the same rate that another incurs loss, keeping you at a break-even point. The key to profitability with this technique is to close out the losing trade before the winning trade has finished its run, allowing the winner to earn a bit more money than the loser lost and leaving you with a modest profit.

the nest