Many new traders have probably read or heard the term ‘hedging’ before, but in most cases it is gravely misunderstood. Hedging can be a good risk management tool, but if an account is not hedged properly it can have devastating effects. Hedging is a more advanced form of risk management and new traders should be very careful with it. Understand how to hedge properly is very important and plenty of research needs to be conducted.
Hedging an account does not automatically mean that the forex traders is protected against trades which move against their prediction and if a forex account is hedged incorrect it will only delay large losses, but not escape them. There are plenty of misconceptions about hedging out there which is why many new forex traders think they are hedging, but in reality are doing nothing more than locking away capital.
How not to hedge an account! When you browse social media or run an online search about hedging you will find the biggest mistake many new traders make. They think that hedging means that you, for example, buy 1.0 lot in the EURUSD at 1.1350 and sell 1.0 lot at 1.1350. This is not how you hedge. Another mistake is buying 1.0 lot in the EURUSD at 1.1350 and selling 1.0 lot in the EURUSD at 1.1300. In both cases the account is not hedged and capital is locked away.
The above two reasons are the biggest two reasons why many claim that hedging does not work and is a waste of time and money. This statement is correct if the account is hedged in any of the above examples because in that case there is no benefit to the trader and it will equal a waste of time and money. With that in mind, the above two examples are examples of how not to hedge a portfolio and before ignoring this risk management tool it is better to take a look at an example of a properly hedged portfolio.
How to hedge your account! For example you will but 1.0 lot in the EURUSD you can hedge this trade with a 0.50 lot short position in the EURCHF, for a partial hedge, or with a short positon of 1.0 lot in the EURCHF. A more popular way of hedging is done by using commodities or indices. For example you buy 1.0 lot in the EURUSD and buy four times 0.25 lots in silver, gold or oil. This should not be done at the same time and it is better to places hedged with multiple entries in the hedge.