What is Hedging and How to Hedge
Hello traders. Welcome to the ProTrading course on the 6th module, hedging. In this lesson, we are going to teach you what hedging is, how does it work, and how you are going to be hedging. Let’s start by defining what hedging is. A hedge is an investment to reduce adverse price movements in an asset. A hedge consists of taking an offsetting position in a related security. For example, if you are long the Euro/US Dollar and want to hedge your trade, you can sell 6E futures contracts which are Euro futures contracts. Because if you are long the Euro/US dollar, you are in fact long the Euro, and if you want to hedge your position, you would want to sell the Euro, and you can do so by selling Euro futures. Hedging is a lot like taking an insurance policy. You are, in fact, insuring your trade against a move against you. This means that, on the same example of the Euro/US Dollar, if you are long, and then price moves against you and retraces more than 50%, then this means that you are going to be losing 50% of the profit you already made with your long trade. But, if you hedge it, you are going to be secured with this move against you because you are going to be long, and you are going to be short at the top.
Now, I’m going to show you how that works and how you are going to do it, but let’s finish up on the definition of hedging. If you are trading spot Forex or CFDs, you can hedge your trade using the same instrument because MT4 has hedging capabilities. This means that you can go both long and short on the same instrument. If we take the example of the long Euro/Us Dollar, this will mean that you can go long on the Euro/US Dollar and when price starts to move against you, you can short the Euro/US Dollar as well. Be advised that not all FX or CFD brokers allow hedging. Also, be advised that by CFDC and NFA ruling, hedging on the same instrument is not permitted in the United States of America.
Now, I’m going to show you an example of how hedging could work in a situation where you have a move against you of more than 50%. Remember that hedging is, well, we are going to use hedging in situations like this because we don’t know if this move against us is actually a retracement, or a full reverse in price. Let’s assume that we are looking at a price right now, and we went long at this level right here. We had a setup to go long, and we went long. Let’s say we are in the money for 200 pips. When we hit a very strong level of resistance at the top of the move. Because we hit a big level of resistance, and we, some of this Belgian golfing candle we are going to hedge our position for a possible retracement back to a possible area of where we are going to come buy here. Let’s say right here, which is the area that we tested once, twice, broke through, and then re-tested again before moving in this very strong move to the upside. What we are going to do here is we are hedge after this Belgian golfing candle. But, because we are hedging, and because we don’t know if price is going to continue to the downside, or just retrace at this level, and then move above the big resistance, we are also going to trail our stop-losses.
Why is it that we trail our stop-losses? Because, when we hedge, we are both long and short at the same time. Pay close attention to what i am going to say because this is the key of successful hedging. We were long, and then we hit a big resistance area. We saw that price made a very strong reversal after it rejected the zone. We shorted the same instrument right here, so we are both long and short at the same time. And ours, well our opinion is that price could retrace to this zone and then move back up. But if price breaks with this zone, then we want to be taken out on our long position because our long bias is no longer valid, and price has fully retraced. This is why we are going to take profit always 50% at a big resistance before hedging. Because it’s not logical that you are going to erase all of your profits, or all of the profits that you made on the long position. Even though you are protected against a move to the downside with your hedge, you still want to make some profit. You are going to take half of your position, and short half a position, so it hedges perfectly. What happens is that price came all the way down here, and the profits that were erased by this move to the downside were hedged by our short position. So, in fact, we already took profits right here, but we are still in full profits because of our short hedge.
Now, what we are going to do, is, well we have two options. We can close our hedge at the zone when we see a bullish reaction to it, and continue with the long trade. Or, we can wait for our stops to be hit, our long position to be taken out on a small profit, and we can continue to ride our short position. In this case, we have closed the short hedge at this level and then price came to the big resistance again, and broke to the upside. This is how you are going to hedge with the same instruments. But remember that you are not always going to hedge your positions. In fact, if is very rare that you are going to be able to do it. And we are going to teach you when not to hedge and when to hedge in further lessons. But, for the time being, I need to show you how a hedge works.
I’m gong to show you how a hedge works with two different instruments. Let’s say that we want to take a bullish position on the Japanese Yen, by shorting the US Dollar/Japanese Yen. We take the bullish position after the retest of this broken area, and we went short right here with our stops above the previous high. Alright, so we have a very nice 80 pip stop-loss and of course our first targets are right here at this zone of support on the daily for 218 pips. This is a very good risk to rewards scenario. What we want to do here, is look for an instrument where we can sell Japanese Yen again our buy positions right here with the short sale on the US Dollar/Japanese Yen. We need instruments that correlate almost perfectly, so we are going to choose to do so on the Euro/Japanese Yen. If you are trading the Euro/US Dollar, you can hedge on the GBP/USD for example. But, if you are looking at making a play on the Yen, US Dollar/Japanese Yen, if you are trading the US Dollar/Japanese Yen. What we are going to do here when the USD/Japanese Yen hits this area right here at 107,657. At around 6PM on March 7th, we go to the Japanese Yen, and we buy this instrument right here.
Why do we buy it? Because we are short the US Dollar/Japanese Yen. So, what we are going to do, in fact, is ride a buy position on the Euro/Yen, while maintaining our short position on the US Dollar/Japanese Yen. Remember that we took profits right here on half of our position, so we are going to half of a position hedge. We are going to look at a zone where price might reverse on both instruments. On the US Dollar/Japanese Yen, is this zone right here, where you could see some sort of a buy pressure with this rejection candle, before continuing to the down side which would mean that the zone we are looking on the Euro/Yen is this one right here. What’s going to happen is that we are going to ride this short position on the US Dollar/Japanese Yen. When we buy the Euro/Yen, we are going to move our stops above, well you can move them to break even or just above this area where we found buyers while going down. But, we broke through and now it’s very possible that sellers are going to be positioned here. Remember that the markets are all about position and risk to reward scenarios.
So, what we are going to do is we are going to play the same thing here on the Euro/Yen. We are going to be riding this short position, or bullish play on the Yen, with a short position on the US Dollar/Japanese Yen, and when we hit these lows, we are going to buy the Euro/Yen. When we buy the Euro/Yen, we move our stops on our position on the US Dollar/Japanese Yen down, and we wait for the Euro/Yen to hit this zone. You can see that we also had a rejection before moving lower right here. When we hit this zone and we see this candlestick formation, that shows a clear rejection and a continuation to the moves to the down side, you can close your hedge for a profit and continue to ride your short position down. And basically, this is how you can hedge on the same instrument or with two different instruments that are correlated to each other.