How to Use Hedging in FOREX Trading
Traders look to profit from changes in a foreign currency pair’s (Forex) price. Traders apply technical analysis to determine optimal entry and exit points. If the analysis is correct, the investor will earn a profit. But the Forex market can also hand traders a loss should price move in the opposite direction. To prevent this, traders can employ different hedging strategies to protect their open positions and their investment capital.
Get paid to keep your positions open. When you buy a currency pair, each currency has its own interest rate. The rollover is the difference between the interest rates. For example, say you are holding the EUR/USD (Euro dollar/U.S. dollar). The Euro has a 3 percent interest rate and the U.S. dollar a 1.25 percent interest rate. Subtract the Euro’s 3 percent from the U.S. dollar’s 1.25 percent, and the rollover rate you are paid is 1.75 percent.Step 2
Protect your long rollover trade by opening a EUR/USD short position with a Forex broker that does not charge for holding short positions overnight. You are now long and short the EUR/USD while getting paid the rollover interest. Your EUR/USD trade is protected whether the price moves up or down.Step 3
Protect against a breakout failure with binary options. Breakout failures occur when a currency pair’s price breaks out in the opposite direction of your trade. With binary options, you guard against a breakout failure by purchasing a short-term option in the opposite direction. For example, you decide to go long the EUR/USD and place a stop-loss at a major support price. You sell a EUR/USD binary option at your stop-loss price. Should the breakout fail, your binary option’s gain will make up the loss incurred by your long position loss and could even return a profit.Step 4
Use currency correlation to hedge your Forex trades. The correlation rating tells you which currency pairs move together or opposite based on price moves. Currency pairs with a +1 rating move together nearly every time. Currency pairs with a -1 rating move opposite each other nearly every time. For example, the EUR/USD and the USD/CHF (U.S. dollar/Swiss franc) have a negative correlation to each other. You can protect your long EUR/USD position by shorting the USD/CHF currency pair. Should the EUR/USD price fall, the USD/CHF pair will gain in value.
- Forex currency correlation ratings change daily. Check the ratings before you enter a trade.
- Forex trading can be very risky. Only trade with money you can afford to lose.
Based in St. Petersburg, Fla., Karen Rogers covers the financial markets for several online publications. She received a bachelor's degree in business administration from the University of South Florida.