In the world of trading, 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.
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 trades 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. 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.
In the simplest explanation, hedging means taking steps to reduce the risk of losing in a trade. This way, even if things go in the opposite direction to what you predicted you will still be protected or will lose less. In forex trading, you can hedge the risk of your trade by opening a trade in the opposite direction. Therefore, if you start to lose from the trade you opened you will automatically start to profit from the hedging trade you opened in the opposite direction.
It can be argued that it makes more sense to close the initial trade for a loss and place a new trade in a better spot and as a trader, you certainly could close your initial trade and enter the market at a better price. The advantage of using the hedge is that you can keep your trade on the market and make money with a second trade that makes profit as the market moves against your first position. When you suspect the market is going to reverse and go back in your initial trades favor, you can set a stop on the hedging trade, or just close it.
The forex currency trading market is a risky one, and hedging is just one way that a trader can help to minimize the amount of risk they take on. So much of being a trader is money and risk management that having another tool like hedging in the arsenal is incredibly useful. However, not all retail forex brokers allow for hedging within their platforms. Be sure to research fully the broker you use before beginning to trade.
