The Comprehensive Forex Hedging Guide for Beginners
The Foreign exchange (Forex) market is a global platform for trading currencies. It is decentralized and free for anyone to participate. Forex trading operates similar to stock trading and determines the foreign exchange rates of world currencies. The Forex market is primarily used in all aspects of currency trading, which includes the following:
- Buying global currency
- Selling global currency
- Exchanging global currency
Like stocks, you can also hedge Forex. To hedge involves taking positions against one another to minimize your risk. It is essentially covering your losses with opposing positions. A common strategy for Forex hedging is to open a long and short position between good pairs such as Euro and US Dollar as a long against US Dollar and Swiss franc as a short.
What is Forex?
Forex is short for the Foreign exchange market. Forex is a decentralized marketplace for trading world currencies. Decentralized means any transactions happen between people without the interference of banks or other third parties. Digital currency, commodities like coffee and cacao, and cryptocurrencies such as Bitcoin are also decentralized in specific markets. One of the great things about Forex is that it is open to anyone. So, people like you can open an account and begin trading today. However, like any trading market, your money is at risk.
But also, like other markets, you can take steps to minimize the risk to your capital (money). In Forex trading, capital refers to the amount of available cash you can invest at a given time. Although it is more complex with data-driven decisions, Forex can be like gambling if you don’t know what you are doing. Therefore, it is recommended that you learn Forex trading before you begin. One of the techniques you should learn is hedging in Forex.
What is Hedging?
Hedging dates back to the early days of trading when farmers in the United States would sell grain to independent traders who then shipped the commodity all over the country. But there was often too much grain – much more than needed. Because of this, much was wasted, forcing debts on farmers and traders alike. So, grain producers came up with the idea of charging an agreed-upon price to be paid upon delivery. By making early “commitments”, farmers knew the exact amount of grain required, and traders knew how much money they needed for a trade.
This is known as “hedging” and essentially secures your position to avoid losses. The strategy is widely used today across all sectors by countless producers, manufacturers, and traders. For instance, aluminium is a widely traded commodity, with fluctuations in price. So, a drinks manufacturer like Coca-Cola can secure their annual expenses by ordering the required aluminium for drink cans in advance. By doing this, they ensure their production costs for the following year. And you can hedge trades in the Forex market as well.
Using Forex hedging, you can protect yourself from a rise or fall in exchange rates. If you use Forex hedging strategies correctly, you can cover your losses if the worst happens. While there are similarities between stock and currency hedging, the two aren’t the same. Forex hedging is best done using currency pairs, and while the concept appears simple, it can be complex. However, if you take the time to practice on some free platforms, you will get a feel for currency pairing. The strategy is best described as follows:
When you buy a currency pair from a forex broker, you buy the base currency and sell the quote currency. Conversely, when you sell the currency pair, you sell the base currency and receive the quote currency. Currency pairs are quoted based on their bid (buy) and ask prices (sell). – Investopedia.
- Forex broker: a middleman company that lets you buy and sell currencies.
- Currency pair: The value of one currency is quoted against the value of another currency.
- Base currency: the first currency mentioned in a currency pair.
- Quote currency: the second currency is used to determine the value of the base currency.
You will always buy Forex currency in pairs because you buy one currency (base) at the same time as selling another (quote) currency. However, it would help if you understood that the currency pair is considered one consolidated unit rather than two separate ones.
How You Can Hedge Forex
First, you must open a trade. Opening a trade means making your first purchase. Following your open, you hold a position. A position is the amount of a particular stock you own. You can close a position to end it at any time, typically when you have made a profit. Stock or property can be short or long. Shorting is when you buy stock to sell if you think the price will go down, and long refers to buying and holding stock to sell when you think the price will go up.
If the opposite occurs in each, you lose money. Otherwise, you will profit. However, market volatility and unpredictability means you can never be 100% sure what will happen. And this is where hedging is useful. By playing two commodities against each other, you can reduce the risk to your investment. So, if your short position gains value or your long position loses it, you may lose little money or none at all. But hedging is a skill you must learn. And when it comes to Forex, there are some fundamentals of which you must be aware.
Forex Trading Terms
In trading, many complex terms are used that are almost like another language. If you don’t take the time to learn these terms, it’s easy to get confused. As you learn Forex trading, you will pick up a variety of terms, but some of the most common Forex terms include:
- Bid: the price at which your currencies are sold.
- Ask: the price at which you buy currencies.
- Spread: the difference between the bid and spread to be used as broker commission.
- Pip: the smallest rise or fall in value a currency can make at one-hundredth of 1%.
- Leverage: 1:100 lending ratio from your broker. A $1 investment lets you trade at $100.
With some of the terms out of the way and a little understanding of what Forex and hedging involve, it’s helpful if you take the time to understand the most crucial thing in Forex hedging: currency pairs.
Understanding Currency Pairs
Currently, there are 28 currency pairs on the Forex market. Any of which you can openly trade. However, seven major pairs make up the majority of trades. These are:
The euro and US dollar
The US dollar and Japanese yen
The British pound sterling and US dollar
The US dollar and Swiss franc
The Australian dollar and US dollar
The US dollar and Canadian dollar
The New Zealand dollar and US dollar
These are the currency pairs you will most likely trade since they are the most profitable. So, for any further reading, pairs from the above table will be referenced to keep things simple.
To read a currency pair, you read the base and the quote. For example, the euro and US dollar pair is read as EUR to USD (EUR/USD). Where EUR is the base, and USD is the quote. The ask (price) refers to the unit pair as a whole and is determined by the quote. So, if the ask is 1.6, then a sale of 1.6 of the quote is required to sell 1 of the base. Therefore a EUR/USD with a bid of 1.6 means 1.6 times US dollars returns 1 euro. This is the exchange rate. Exchange rates fluctuate all the time because of the different time zones.
But because of time zones, you can trade currencies 24 hours per day, five days a week. It seems complex at first, but you will get the hang of it with a bit of practice.
Popular Apps for Practicing Forex Trades
One of the best ways to learn how to trade and hedge on the foreign exchange is to practice. Many great apps let you do this. All you need is an email account and a smartphone or computer. Practicing is great fun, and with many of the internet’s available tools, you can easily find a Forex trading course for beginners. In addition, these apps and tools open up trading like never before. In the old days, this wasn’t possible, which meant trading wasn’t as accessible as it is today.
With some of these apps, you can get practicing in minutes. However, you should be aware that you must be verified using a nationally recognized identification method such as a passport for live trading with real money, as per international trading regulations.
Some of the best apps for practicing Forex trading are as follows:
- Pepperstone: best for MT4 demo
- Markets.com: best for MT5 demo
- IC Markets: best for overall demo
- Plus 500: offers risk tools demo
- eToro: has a strong social aspect
- FXCM: offers charting tools practice
- Oanda: offers unlimited demo access
- IG: best for UK Forex trading demo
- ThinkMarkets: best overall for demo for mobile trading
- TD Ameritrade: best for USA trading practice
Some platforms are a little different, such as MT4 and MT5. But to learn Forex trading, you will typically only concern yourself with the MT4 platform. MT5 is for more advanced users and offers a wide range of applications such as trading stocks and futures.
When to Hedge Forex
Hedging is described in simple terms as insuring your trade. If something goes wrong, you can recover. But knowing when to hedge and with what currencies is the skill involved in Forex hedging. For the most part, hedging is not a profit-making strategy. However, very experienced traders can gain from hedging. For the most part, you will use hedging as a cushion against problems. Short-term hedges are the best method for beginners because they can protect profits when you’re not sure what will happen at any given moment.
Exiting a Forex Hedge
Hedging in Forex involves holding both a short and long position on the same pair. This means that you are covered in all eventualities if a short value increases or a long value decreases. While there is no guarantee you are fully protected, you can weather the storm. Eventually, you will need to exit a hedge. When exiting a hedge and keeping your initial long or short position open, you need to close out only the second position. However, if you want to close your position fully, close both sides at the same time to reduce the adverse effects of a gap.
Risks You Should be Aware Of
If you don’t understand hedging strategies, you take on a massive risk because of the sheer complexities of trading. Because of this, even the best strategies can never 100% guarantee your protection. For this reason, you shouldn’t engage in hedging until you have a solid understanding of how trading works, the timing of trades and currency pairing, or you will lose money. You should also be aware that hedging is designed for short-term risk management and doesn’t apply well to long-term holdings.
The forex market works like stock trading, determining foreign exchange rates. However, hedging allows you to protect your position. You do this by opening long and short positions to counteract rising or falling prices. Currency trading can be complicated, but you can get a feel for it by practicing on some free platforms. And don’t forget to take the time to practice hedging, as well. In Forex hedging, the skill is knowing when to hedge and with what currencies. But hedging isn’t a way to make money. Instead, it’s an insurance policy against market volatility, and it isn’t guaranteed.
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