Forex Hedging Systems - are They Useful?
There are many Forex retail traders who attempt to hedge their trades after suffering from substantial equity losses. While this may seem like a good way to limit their losses, a hedging strategy may not necessarily be any help at all. In this article, I will discuss why hedging trades may be a bad idea if you want to limit your trading losses.
What Is Hedging?
The objective of hedging a trade is to reduce the potential losses that may otherwise have been incurred without the hedge.
For example, let's say I go long on the EUR/USD at price 1.4030. The market immediately goes against me an plunges to 1.4010, resulting in an unrealized loss of -20 pips.
In order to hedge against further losses, I enter into a second trade: shorting at 1.4010 (which is the current market price). This way, if prices fall even further, at least I won't lose any more pips. If prices fall by a further 5 pips, I would lose 5 pips in my initial long position and gain 5 pips in my second short position, netting a total of zero pips.
The Problem With Hedging In This Manner
This form of hedging is very attractive to inexperienced traders who don't really understand what they're doing. At first glance, it looks as if hedging can stop a trader from suffering from further losses, while allowing for the potential of the trade to turn around in his favour. And this is the exact manner of thinking that causes many traders to mistakenly enter into hedging trades like the one I just showed you.
Here's the problem with this method of hedging:
Even if price do turn around in my favour and moves back up to the price of 1.4030, I will still be suffering from an unrealized loss of -20 pips! Why?
Because even though my initial long trade broke even (current market price at 1.4030 is the same price I went long), my second short trade will be suffering from a -20 pip unrealized loss (remember I shorted at 1.4010), netting a total unrealized loss of -20 pips!
Can you see how that even when prices manage to go back up in my favour, hedging STILL causes me to lose money? If I didn't hedge at all, I would have at least broken even by now.
And that's not all. Because I entered into a second (hedging) trade, I had to pay extra transaction fees via the bid/ask spread!
What Is Hedging?
The objective of hedging a trade is to reduce the potential losses that may otherwise have been incurred without the hedge.
For example, let's say I go long on the EUR/USD at price 1.4030. The market immediately goes against me an plunges to 1.4010, resulting in an unrealized loss of -20 pips.
In order to hedge against further losses, I enter into a second trade: shorting at 1.4010 (which is the current market price). This way, if prices fall even further, at least I won't lose any more pips. If prices fall by a further 5 pips, I would lose 5 pips in my initial long position and gain 5 pips in my second short position, netting a total of zero pips.
The Problem With Hedging In This Manner
This form of hedging is very attractive to inexperienced traders who don't really understand what they're doing. At first glance, it looks as if hedging can stop a trader from suffering from further losses, while allowing for the potential of the trade to turn around in his favour. And this is the exact manner of thinking that causes many traders to mistakenly enter into hedging trades like the one I just showed you.
Here's the problem with this method of hedging:
Even if price do turn around in my favour and moves back up to the price of 1.4030, I will still be suffering from an unrealized loss of -20 pips! Why?
Because even though my initial long trade broke even (current market price at 1.4030 is the same price I went long), my second short trade will be suffering from a -20 pip unrealized loss (remember I shorted at 1.4010), netting a total unrealized loss of -20 pips!
Can you see how that even when prices manage to go back up in my favour, hedging STILL causes me to lose money? If I didn't hedge at all, I would have at least broken even by now.
And that's not all. Because I entered into a second (hedging) trade, I had to pay extra transaction fees via the bid/ask spread!
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