Part of a sound money management system, hedging is an important tool to be used when trading the Forex market. There are advantages and disadvantages to hedging, but mostly it is being viewed as a tool that helps a trader.
Hedging is not allowed everywhere in the world. In the United States, hedging is not allowed and Forex brokers need to adapt to these regulations.
Consequently, the most popular trading platform, MetaTrader 4, had an update, or a new version, that is not allowing hedging positions: MetaTrader 5. Therefore, the preferred trading platform among U.S. traders is MetaTrader 5.
However, while hedging is not allowed on the same trading account, the U.S. traders simply use two or more trading accounts to avoid this issue. They can be either with the same broker or with different brokers.
Why would anyone hedge an account? What does hedging even means?
To hedge a position in a trading account, traders are taking one position in the opposite direction, without closing the original one. In doing that, the original position is being hedged, and the trader is not losing nor winning on average. Why would anyone want to do that? The answer is simple: it comes from the trading strategy that is being used.
For example, if the same strategy is being used on the same timeframes of a currency pair, different trades may result. No one trades on the monthly chart, but a golden cross, for example (when two moving averages are crossing generating a bullish signal), may be a buying signal on the weekly chart and a bearish cross (when two moving averages are crossing generating a bearish signal) may be a selling signal on the hourly chart.
Traders will take both trades, one on the long side and the other one on the short side. If both trades are open, and assuming the traded volume is the same, the equity in the trading account will not change, no matter the direction the market is moving.
The only thing that is going to be deducted as an expense in the trading account is the negative swap (if any) that will be calculated at the end of the trading day when the positions are rolled over into the next day. The rest is perfectly balanced.
By the time the hourly time frame trade reaches take profit or stop loss, the other trade generated on the weekly time frame will still be open. Imagine this being done on two or three or more time frames, and you have a perfectly integrate hedging system for a trading account.
There are multiple ways to hedge a trading account. The one described above is called a fully hedged position. It means that the same volume is open in both directions. But a trading account can be partially hedged.
At this moment, or at the moment the positions were opened, the commission is deducted from the balance of the trading account for both trades. There is no swap yet as the positions were not kept overnight.
If, say, the short trade was only half a lot, it is being said that the trade was partially hedged. In any case, fully or partial hedging, there is a margin that is blocked.
To put it more exact, imagine the following. When opening a new position in a trading account, the Forex broker is blocking a margin corresponding to the volume of that trade and the leverage in the trading account.
As a rule of thumb, the bigger the leverage, the bigger the risk and the smaller the amount blocked. This amount acts as a “collateral” for the opened trade.
If things go against the desired direction and there is a need to open a trade in the opposite direction, for one of the reasons explained earlier, part of the margin needed for the original trade is released.
This gives the possibility for new trades to be open. Moreover, with the newly released margin, the account gets a “boost” in the free margin level and drawdowns can be easily sustained.
The two methods to hedge a position or a trading account are not the only methods that can be used. Correlations are as effective too.
Within the currency pairs that form the Forex dashboard, there are correlated pairs. That is, pairs that move in the same direction, or in the opposite direction, most of the times.
For example, take the U.S. dollar pairs, like the GBPUSD and EURUSD. They move in the same direction on a dollar driven news.
To hedge an account using correlations, if one is long the EURUSD pair, can sell the GBPUSD. A good reason to do that would be to use bigger time frames and different expectations for the second trade.
Given the fact that the pairs are directly correlated, it is considered that the whole trading account is partially hedged. This approach is used in the areas of the world where hedging is not allowed.
Another good example is the inverted correlation between the AUDUSD pair and the USDCAD one. They move in opposite directions most of the time.
While it is not that actual anymore, risk-off and risk-on environments influenced trading for many years. Under a risk-on move, the EURUSD, GBPUSD, NZDUSD, AUDUSD and the DJIA moved to the upside, while USDCAD moved to the downside, with the opposite being true as well in the case of a risk-off move.
Overtrading was a major risk under these conditions as if one bought the EURSUD and the GBPUSD on the same account it was like buying two times the EURUSD pair. Partially hedging a risk-on environment meant that the USDCAD would be traded to the UPSIDE, while everything else remained the same.