Forex trading represents selling or buying in the foreign exchange market with the idea of speculating the moves that characterize this market. That is, if you think a currency pair is bound to move to the upside, a long trade should be taken. This means the currency pair has been bought.
If the pair is indeed moving to the upside, a profit is being made based on the difference between the exit and entry price. Of course, the opposite is true when going short or selling a currency pair based on expectations that the pair is going to move to the downside.
The currency pairs are moving based on either fundamental news (economic news to be found out by checking the economic calendar) or technical levels (traders using technical analysis to find places where prices are most likely to react). In both cases, a currency pair can either be bought or sold.
Can a currency pair be bought and sold at the same time? The answer is yes; and this is hedging. There are many hedging strategies out there and many reasons why traders are using them, but mostly hedging is used to mitigate risk.
A full hedged account is an account that is having equally long and short positions for all the instruments that are being open. Traders chose to fully hedge a trading account when market is moving against them and they consider that the move is only a temporary one.
For example, it may very well be that an impulsive wave is completed and the trader doesn’t want to close the trades, even if they are in profit, as the impulsive wave is only the first wave of a five-wave structure of a bigger degree. In this case, the logical action is to fully hedge the position until the 2nd wave is completed.
When this happens, the profits for the hedged trade can be booked and the trades that are remaining open, the original ones, will benefit again from the newly resumed trend. This is one way to use hedging.
Another way is when traders have a technical setup based on different technical indicators and that setup is applied to multiple time frames. It can be moving averages cross coupled with some oscillator crosses, etc., but because it is applied on the same currency pair but on different time frames, it means that the signals generated can be different on the same currency pair.
In other words; the hourly chart may give a buy signal, while the daily chart is showing a sell one. How to trade such contrarian signals? The answer comes from hedging. All trades can be taken, no matter the time frame, and at any one moment of time the account may end up being fully or partially hedged.
A big advantage when hedging is that margin is released and that margin can be used to open other trades. When traders are opening a position, a margin in the trading account is blocked based on the volume that is traded and the currency pair as well.
In the case of a hedged trade, more than half of that margin is being released as the new trade’s margin will almost completely offset the margin blocked on the original trade. This is a big advantage for hedging and one of the main reasons it is being used in forex trading.
Hedging doesn’t necessarily mean that it refers to the same currency pair. Using the risk-off/risk-on approach, an account can be partially hedged. This is valid when correlated pairs are being traded.
For example, let’s assume the US dollar, the world’s reserve currency, is suffering from economic news, and the EURUSD, AUDUSD, GBPUSD, NZDUSD, all pairs are moving to the upside consequently. However, the percentage degree of the move is not the same on all pairs.
To partially hedge an account that has such positions open, one can take a long USDCAD trade. In a risk-on/risk-off situation, the USDCAD pair is inversely correlated with the pairs mentioned above. This makes a long trade in the USDCAD, offsetting the overall exposure.
Overtrading, in general, is one of the main reasons why traders fail in the forex exchange market as greed and fear result in opening too many positions in the same direction. Hedging is one way to avoid this.
Not all traders can use hedging, though, as not all brokers are offering accounts that allow that. Brokers in the United States are not allowing their traders to hedge a position.
One way to overcome this situation is to trade with two or more brokers and to hedge the position on different accounts. This means that at one moment of time one will be long a currency pair on one account, and short on another.