Hedging is a unique concept in the financial markets, which allows an investor to moderate his risks against market volatility. Hedging, in its different forms, is adopted by various traders and investors from all over the globe, but the Forex market has a unique twist to the hedging strategy that is deemed to be illegal in several financial markets, mainly the US.
Hedging in the market involves a trader investing in multiple positions to minimize the risk by taking a negligible loss or a small profit, irrespective of the market volatility. The primary goal behind hedging is to cover all market eventualities and to prevent significant losses in trading. Hedging is used by traders if they are not sure about the future course of the market, and if they anticipate massive swings on either side of their trade position due to unpredictable news outcomes.
In Forex trading, hedging works on the principle of a trader buying and selling a currency (or multiple currencies) at a single entry price or two different strike prices to ensure that he is protected even if the market swings violently in either direction. The process of hedging involves a single currency pair or two different currency pairs that have a common base currency. Some traders also use correlation to find different currency pairs with positive or negative correlation with each other, and then enters a buy or sell position according to their market analysis.
In the case of a positive correlation, most traders usually go long on currency pairs that are expected to rise, while they can go short on those currency pairs that are expected to decline. In a negative correlation, traders go long on the first currency pair while going short on the correlated asset. Sometimes, traders might also use a combination of positive and negative correlation to hedge their positions. Although hedging is not considered as an alternative to strategies that use technical or fundamental analysis, hedging is deemed to be a proactive trading style that helps in reducing large drawdowns.
Hedging is considered to be a low-risk strategy with very limited potential for both profits and losses. Hedging can be regarded as a profitable strategy only if a trader is experienced and can make profitable trades by accounting for all the costs of trading without succumbing to the pitfalls of a market. Ultimately, hedging should be considered as any other trading strategy, and should be treated as such.
Is Hedging Legal?
As previously mentioned, the concept of hedging in Forex trading is deemed to be illegal in the US. Of course, not all forms of hedging are considered illegal, but the act of buying and selling the same currency pair at the same or different strike prices are deemed to be illegal. The CFTC has implemented several trading restrictions on Forex traders, the primary among them being the ability to hedge a position on the same currency pair.
To ensure that all traders and brokers in the US adhere to this ruling, the CFTC has mandated brokers to incorporate the OCO (One Cancels Other) order into their platform, which typically prevents traders from hedging on the same currency pair. The CFTC has also enforced the FIFO rule, which requires traders to liquidate their open positions only in the order they were opened. Therefore, under the FIFO rule, multiple positions on the same currency pairs will be closed even if a trader closes the most recent trade opened on his terminal.
On the other hand, hedging is considered to be a legal trading strategy by a majority of brokers around the world, including those from EU, Asia, and Australia. Most international brokers typically cater to hedging strategies as brokers earn twice the spread from hedgers than regular traders. The primary reason given by CFTC for the ban on hedging was due to the double costs of trading and the inconsequential trading outcome, which always gives the edge to the broker than the trader. However, as far as Forex trading is concerned, a trader should have the freedom to trade the market the way he sees fit.
Are Hedging Strategies Profitable?
The profitability of hedging is questionable, especially for novice and amateur traders. Hedging involves more than double the cost of opening regular trades, which can act against a trader if he is not careful about entering and exiting the market at the right time. Therefore, as with all Forex trading strategies, there are both risks as well as profit potential regarding hedging.
The main benefit of using a hedging strategy is that traders can minimize their losses and avoid massive drawdowns, especially during highly volatile market conditions. News, rate decisions, and other economic events can trigger significant movements in the market, which can result in massive losses. By hedging against such moves, traders can limit their losses and preserve their trading capital for the future.
Traders should also be aware that Forex trading is not a zero sum game due to the spreads, commissions, and swaps that are charged for every order. A trader can lose more than 90% of his entire trading capital by just opening and closing 25 hedged positions at 2 pips spread per order, and a leverage of 1:100. Although hedging might seem to be a low-risk strategy, you can lose more than your equity through spreads and other costs.
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If you are a trader from the US, you are legally barred from hedging. To make matters worse, US traders are not allowed to open an account at any overseas broker, which prevents them from adopting any hedging strategies in the Forex markets. However, if you are not from the US, you have many options for hedging Forex brokers, as almost all mainstream international brokers offer hedging functionality without any restrictions.
You should consider hedging only after examining its pros and cons and if it is indeed considered to be legal in your jurisdiction. Of course, every strategy will require careful analysis of the markets and a good amount of discipline; however, you may adopt a hedging strategy if it is helping you to improve your success in the market.