Learn how to trade using hedging, a safe and secure way to invest online. Check out our list of the best online brokers that allow hedging and start investing reliably.
What is hedging?
The term hedging means hedging in English. In a broad sense, hedging is a trading strategy used to reduce or even eliminate the risk of loss in financial activities and is carried out by both retail investors and professional traders. The most common form of hedging is through the use of futures contracts, swaps, options or other financial derivatives.
What is financial hedging and what is it for?
In some ways, hedging can be likened to insurance contracts in that both seek to protect us in the event of a future event. For example, home, fire or accident insurance protects us from certain unfavourable future circumstances, just as hedging in financial activities is based on protecting the investor in case the financial market evolves in a way that is unfavourable to the investor’s position.
In financial terms, hedging is when we open an opposite position to our investment. In this way, if the price of the financial asset develops unfavourably to our initial operation, we would reduce the risk of capital loss. One thing to bear in mind is that opening double positions reduces the risk of losing money, but also limits our profit possibilities and entails the payment of two commissions.
What is hedging in Forex?
Forex hedging is a type of trading strategy widely used by all types of investors as it helps to protect their accounts against losses due to excessive fluctuation or unexpected movements in the financial market. Forex hedging can be understood as a partial insurance against unfavourable circumstances resulting in capital losses.
There are two basic types of Forex hedging strategies: simple hedging and complex hedging. Below we explain the characteristics of each:
Hedging or simple hedging
Simple hedging is the most commonly used and consists of opening two opposite Forex positions on the same currency pair. It is also called direct hedging and allows us to open a position in one direction and another in the opposite direction while the initial one remains open. If we take a long position of 2.5 lots in EUR/USD, our hedging position will be a short position of the same value (2.5 lots) in the same pair (EUR/USD). The two trades are done at the same time and from the same trading account.
Most Forex traders use hedging trades in the following manner: they will first open one position and if the market moves in the opposite direction then they open a second position opposite to the first. If the currency pair they are trading moves significantly, then they will adjust the positions (long and short) so that the two trades together are as favourable as possible.
Hedging or complex hedging
This form of hedging is frequently used by professional traders and hedge funds and often allows them to generate large profits even when financial markets are falling sharply. Complex hedging consists of opening Forex positions in both the Forex options market and their counterparts in the Spot Forex market.
Of course, this is done with the intention of limiting the risk of losing money on unexpected developments but, depending on the number of contracts purchased, we may even be able to benefit from unexpected fluctuations.
An example of a complex hedge would be to open a position in the spot forex market on EUR/GBP in the expectation that sterling will depreciate. At the same time, we will buy an option with a lower strike price than the previous trade. If the value of EUR/GBP develops favourably, we will benefit from the spot market position and only have to pay the option premium. If the pair develops unfavourably, we will close the spot position at the stop loss while still being able to profit from the option.
How to choose an online broker that allows hedging
When choosing which online Forex broker to use for trading, it is important to pay attention to a number of features common to all recommended online brokers. At OkBrokers we analyse each online broker so that you can choose the one that best suits your needs. In the list you will find on this page we only include online brokers that allow hedging and that have also passed our quality tests. In these tests we assess aspects such as the following:
1. Only regulated brokers
By choosing regulated brokers you ensure that they operate legally and in accordance with the rules set out by reputable regulatory authorities such as the Financial Conduct Authority that enforce compliance with regulations governing the use of hedging. Regulated brokers will generally offer the best conditions for traders.
2. Types of Hedging permitted by the broker
Each broker decides the types of trading strategies that its users can use. Make sure that the online broker you choose to deposit your capital with offers the type of hedging you usually use.
Type of account and minimum capital
If we use hedging when trading, we will need twice as much capital as necessary because we are not hedging transactions. This is why it is a trading strategy commonly adopted by traders with considerable capital.
Advantages of Hedging
- In some cases traders can protect their investments against any losses by using hedging strategies.
- When markets are highly volatile, hedging is an indispensable tool for any investor.
- Becoming familiar with the use of hedging strategies is an indispensable step in the evolution of any financial career.
Disadvantages of Hedging
- It is not always possible to hedge your investment against market movements and therefore hedging cannot be considered a foolproof strategy.
- Hedged trading multiplies costs by generating commissions on each position.
- It is a more favourable strategy for large investors.
Hedging by applying the hedging strategy is advisable as it reduces the risk of losing money, even though it limits our potential gains. If you decide to trade in this way, we advise you to do so with a reliable and regulated online broker.
As always, we would like to end with a risk warning: hedging, like any other form of trading, carries risks of capital loss. In fact, most retail investors lose money when trading complex derivatives. Make sure you have the right knowledge before making any investment and never risk more capital than you can afford to lose.
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