Guide to investing with Hedging

What is hedging?

The Anglo-Saxon term hedging means coverage in Spanish. In a broad sense, hedging is a trading strategy used to reduce or even eliminate the risk of losses in financial activities and it is carried out by both retail investors and professional traders. The most common way to carry out hedging operations is through the use of futures contracts, swaps, options or other financial derivatives.

What is financial coverage and what is it for?

In a way, hedging can resemble insurance contracts in that they both try to protect us in the event of a future event. For example, home, fire or accident insurance protects us from certain unfavorable future circumstances, just as hedging in financial activities is based on protecting the investor in the event that the financial market evolves in an unfavorable way to his position. .

In financial terms, it would be considered hedging when we open a position contrary to our investment. With this, if the price of the financial asset evolves unfavorably to our initial operation, we would reduce the risk of loss of capital. Something to keep in mind is that the opening of double positions reduces the risk of losing money but also limits our possibilities of profit 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 generated by excessive fluctuation or unexpected movements in the financial market. We can understand Forex hedging as a partial insurance against unfavorable circumstances that result in capital losses.

There are two basic types of Forex  hedging strategies: simple hedging and complex hedging . Here we explain the characteristics of each one:

Hedging or simple coverage

Simple hedging is the most used and consists of opening two opposing 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 must be a short position of the same value (2.5 lots) in the same pair (EUR / USD). The two operations are carried out at the same time and from the same trading account.

Most Forex traders use hedging operations in the following way: first they will 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 in which they are trading moves significantly, then they will adjust the positions (long and short) so that the combination of the two operations is as favorable as possible.

Hedging or complex coverage

This modality of hedging is frequently used by professional traders and hedge funds and often allows them to generate large profits even when the financial markets show large declines. The hedging complex is to open Forex positions in both the Forex options market and contrary Spot Forex market.

Of course, this is done with the intention of limiting the risk of losing money to unexpected developments but, depending on the number of contracts acquired, we may even benefit from unexpected fluctuations.

An example of complex hedging would be to open a position in the spot forex market on the EUR / GBP pair waiting for the British pound to depreciate. At the same time we will acquire an option with a lower execution price than the previous operation. If the value of the EUR / GBP evolves favorably, we will benefit from the position in the spot market and we will only have to pay the option premium. In the event that the pair evolves unfavorably, we will close the spot position at the stop loss while we can still benefit from the option.

How to choose an online broker that allows hedging

When choosing the online Forex broker that we will use to operate, it is important to pay attention to a series of characteristics common to all recommended online brokers. At OkBrokers we analyze each online broker so that you can choose the one that best suits your needs. In the list that you will find on this page we only include online brokers that allow hedging and that have also passed our quality tests. In them we value aspects such as the following:

1. Only regulated brokers

By choosing regulated brokers, you ensure that they operate legally and following the standards established by prestigious regulatory authorities such as the Financial Conduct Authority that ensure compliance with the regulations that regulate the use of hedging. Regulated brokers, in general, will offer the best conditions for traders.

2. Types of Hedging allowed by the broker

Each broker decides the types of trading strategy that its users can use. Make sure that the online broker in which you decide to deposit your capital offers the type of coverage that you usually use.

3. Type of account and minimum capital

If we use hedging when trading, we will need twice as much capital as necessary by not conducting hedging transactions. For this reason, it is a trading strategy commonly adopted by traders who handle considerable capital.

Advantages of Hedging

• In some cases, traders can protect their investments against any loss thanks to the use of hedging strategies.
• When markets are highly volatile, hedging is an indispensable tool for any investor.
• Familiarizing yourself 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 our investment against market movements and, therefore, hedging cannot be considered an infallible strategy.
• Trading with risk coverage multiplies the costs by generating commissions for each position.
• It is a more favorable strategy for large investors.

Conclution

Carrying out hedging operations through the application of the hedging strategy is recommended since it reduces the risk of losing money and even though it limits our possible gains. If you decide to operate 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: trading hedging, like any other form of trading, carries risks of loss of capital . 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.