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Hedging

Hedging is the parctice of protecting client's funds from unfavorable price fluctuations by opening a position in a contrary or opposing market.
Hedging: ensures protection from possible losses by the time of forward deal settlement; provides higher transactions flexibility and efficiency; reduces the costs related to trading real commodities; lowers the risks of losses as the changes in commodities prices are offset by the profit on futures.

As a rule, losses are limited either upon reaching the stop loss or when the price reverses and goes in the right direction. These scenarios are well-known, so there is no need to give them a closer look now. The thing is that traders who do not use money management bite off more than they can chew, while those who do not use risk management always attack but never defend.

Hedging on Forex is an essential element of protection against the risks and a guarantee of profit. Here is a simple example: you have opened a sell position on the EUR/USD pair based on the signals from the MACD indicator. Then, you got profit three times in a row. But suddenly the price has moved upwards, and your losses are growing for the past twenty four hours. This is where hedging takes place. So, how to do it correctly? A little maths and analysis will help us.

Position locking is also a popular tool, which is ineffective at best and which is often a self-deception. Moreover, it always comes with a negative swap, because the positive swap on the pair is less than the negative one. As a result, this action as such hardly differs from the position reversal based on the continuation of the movement and then on its complete return to the first position’s point.

Thus, the reason for any losses is an unexpected currency move (referring to the currency market). Note that it is the currency, not the currency pair! If you see that the reason for losses on the sell position on the EUR/USD pair lies in the falling dollar, then it is quite possible to take advantage of this situation by transferring the asset to another currency pair without the US dollar. In order to do this, it is necessary to determine the following:

1) Find the pair or pairs that correlate well with EUR/USD.

2) Make sure this instrument (-s) are more volatile than the first one(-s) so that the profit exceeds loss.

3) Open an opposite position (-s) on the US dollar. Important: positions should be opened in equal proportions.

It matters because the EUR/USD lot is not equal to the GBP/USD lot. The difference lies in the price per pip (for example, USD/JPY) and the volatility of a pair. These factors should be allowed for in order to transfer the position to another pair effectively. Otherwise, the discrepancies can become too serious. The initial balance is more important for us, then comes greater profit in relation to losses. The next goal is to achieve a swing effect after the rally ends which brings losses on the EUR/USD pair and generates profit on GBP/USD. A strong movement is followed by the consolidation phase, and at a certain moment, the losses on the first pair are reducing. At this point, you have great chances of exiting a position with profit. The total positive swaps will give you additional support. In fact, using this method, you can transfer the invested assets to the EUR/GDP pair. We took a simple example. However, more complex combinations with additional currency pairs can be used in order to achieve better results.

In order to determine the degree of correlation, the algorithm based on the formula of linear correlation is usually used, which is attached to the MT4 indicator. It is also worth noting that hedging methods are quite diverse. Thus, the given example could also use the pairs without common currencies. However, in this case,  the profit/loss spread could be higher. The key to hedging is achieving the needed balance by diversifying your funds.

Types of hedging:

Classical hedging

Classical hedging implies holding the opposite positions in the market. This hedging method was used by the dealers of the farm products in Chicago, USA.

Full and partial hedging

Full hedging involves the protection against risks for the whole sum of the transaction. This type of hedging completely eliminates possible losses related to price risks. Partial hedging insures only a part of the actual transaction.

Anticipatory hedging

Anticipatory hedging involves buying or selling well before a deal is coplated in the physical market. In the period between the conclusion of a deal in the futures market and the conclusion of a deal in the physical market, a futures contract serves as a substitute for a real contract for the supply of goods. Also anticipatory hedging can be applied through the purchase or sale of an urgent commodity and its subsequent execution via the stock exchange. This type of hedging is the most common in the stock market.

Selective hedging

In selective hedging, the deals in the futures market and spot market vary in the volume and time of order execution.

Cross hedging

Cross hedging is characterized by the fact that the operation in the futures market involves a contract not on the underlying asset in the physical market, but on another financial instrument. For example, on the real market there are operations with shares, while the futures market trades futures using stock indices.

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