Hedging Strategies for Forex Traders

12/09/2013 9:00 am EST

Focus: FOREX

If executed well, a hedging strategy can result in profits for both the directional and hedging trades, writes the staff at FXTM.

Hedging describes the process of buying one asset and selling another in the hope that the losses on one trade will be offset by the gains made on another trade. It works best when the two assets in question are negatively correlated as this will produce the most effective hedge and this means that forex pairs are ideal for hedging.

If executed well, a hedging strategy can result in profits for both trades. What follows is a hedging strategy designed for the currency markets.

UK or US Open
The first step to implementing the hedging strategy relies on watching the market during the first hour of either the US or UK open. It is during this time that market activity is at its peak and this period often sets the tone for the rest of the day.

Examine the whole forex space and get an idea for which currencies are going up and which are going down versus the US dollar. Then, pick the currency that has fallen or risen the least, this will be your directional trade, and pick another pair that should stay relatively flat, this will be your hedge trade.

As an example, let’s say that in the first hour after the UK open, the US dollar is showing a lot of strength. EUR/USD is down -0.20%, GBP/USD is down -0.45%, CAD/USD is down -0.40% and JPY/USD is down -0.65%.

As we can see, EUR/USD is down the least so we will pick this pair as our directional trade. Because EUR/USD is down the least, it is showing the most comparative strength. That means, when the market changes direction EUR/USD will go higher more than the other pairs.

Now that we have chosen to buy EUR/USD as our directional trade we need to pick a currency pair in which to sell EUR against in order to create a hedge. In this case, since we can see that JPY is showing the most comparative weakness, so a good choice would be EUR/JPY. Our hedge trade is therefore to buy EUR/USD and go short EUR/JPY. Risk should be kept the same for both trades so that the profit per pip is exactly equal for both pairs.

Valid for One Session
The hedging strategy works because it takes advantage of momentum. In other words, the strength in the euro (EUR) and the weakness in the Japanese yen (JPY) are both exploited and since the open is the most important period for currency pairs, this momentum should persist until the next session.

One hour before the next session begins, the momentum is likely to converge as new players join the market so it is at this time that the hedge trade should be closed. As the next session begins you can begin to look out for the next hedge trade.

By the Staff at FXTM

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