How do we hedge in trading? With a good hedging strategy, we can make money whether the market goes up or down. You don't always see hedge positions but when you do, it can be a strategy that will give you an edge in the market.
What you will learn from this:
We want to be in a position where we can make money no matter the direction of the market.
Why do we Hedge?
When you get into trading, it’s always a matter between winning a trade and losing a trade. What is our job as a trader then? It’s to protect our capital during the period of which the market moves up and down.
Finding a hedge does the work properly, it helps us to protect ourselves from volatility on one specific market, no matter which way it goes.
Let’s say some news event took place and it pushed the market either up or down, we would want to be in a position where we can make money despite the market movement. When we hedge, we limit our risk to the market as well.
When we say we buy a pair, what are we doing exactly?
Let’s say we are going long on EURUSD, what really happens is that we are looking to earn profit when EUR strengthens in comparison to USD. If the price of EURUSD drops, that is an indication which EUR weakens in comparison to USD strengths.
How do we Hedge?
The way to hedge is simple: we find long exposure on the currency in question and we also find short exposure on the currency in question.
Let’s take a look at the two trades here for example.
If we are to look for a trade to hedge on, we would need to find trades that require strength in CAD and weakness in CAD for us to be able to hedge. In the example above, what we are doing is we are looking for strength in USD, and weakness in CAD for us to be in profit. In another way, if we are to short in NZDCAD, what we are doing is we are looking for weakness in NZD, and strength in CAD for us to be in profit.
Hedging it the right way
Let’s say you’re having a long position on EURUSD. What would be the correct way to hedge the pairs?
- Long EURUSD, Long GBPUSD
- Long EURUSD, Short USDJPY
- Long EURUSD, Short EURJPY
Got your answers?
Only option 3 is the correct way to hedge the pairs, with one trade looking for profit in EUR strengths (Long EURUSD), and another trade looking for profit in EUR weakness (Short EURJPY).