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Forex Day Trading Strategies: Hedging

Forex Day Trading Strategies: Hedging
May 04
04:04 2011

The term “hedging” in financial terminology generally refers to a position or an investment established with the objective of eliminating or reducing the risk assumed on another investment or position.

Consequently, the reasoning behind the hedging strategy is to reduce the investor or trader’s exposure to market risk in a significant way. Forex traders often profit from hedges by putting them on and then strategically unwinding them as the currency market fluctuates.

A number of different ways exist for a forex trader to hedge a position in a particular currency pair. These strategies might include:

  • Taking a position which offsets the original position in the same currency pair
  • Taking a position which reduces risk in another well correlated currency pair
  • Taking an offsetting position using currency options

This article’s focus will be on the first two hedging strategies, which do not require knowledge of options trading.

An Example of Hedging in AUD/USD

If a forex trader is holding a long position in AUD/USD, the trader might opt to hedge the trade against a decline in the rate by offsetting all or part of the position.

This can most easily be accomplished by placing an opposing trade in AUD/USD. In other words, by simply selling or going short the rate.

The remaining hedged position would then not be affected by fluctuations in the AUD/USD exchange rate, and the trader would lock in the difference between the long and offsetting short positions.

Hedging as a Forex Day Trading Strategy

Forex day traders have found that initiating a hedged position in a currency pair can be traded by “legging” out of one side of the position. The remaining currency position can then be subsequently liquidated, hopefully for a profit once the market has moved in the desired direction.

Trading hedged positions offers the day trader the opportunity to take advantage of market volatility, selling the long side when the market rises and buying in the short side when the market sells off.

In addition, this type of strategy can be used when significant economic data is released, increasing volatility in the markets. For example, the forex day trader may put on a hedged trade in EUR/USD just before a significant release, such as U.S. Non-Farm Payrolls.

Right after the release, the market in EUR/USD might rise considerably. This would lead the trader to sell the long side of the hedge and then wait for a pull back to buy in the short side. Additional measures could include placing take profit orders at certain levels to make a profitable outcome more likely.

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Today’s Day Trader Strategy

One of the most common and destructive mistakes a day trader makes is to simply not follow their plans. Temptation, an “obvious signal”, and just simple greed can lead traders down the road of being undisciplined. This is without a doubt one of the most dangerous mistakes, as traders will often lose more than they originally planned as they raised their amount risked.