Explaining a key risk tool
Managing your risk is a vital part of trading and hedging is one of the most popular methods to achieve it. It lets you protect your trades and limit the risk from unwanted movements that go against your positions.
So what is hedging? The simple definition of hedging in trading is when you make a trade in the opposite direction of one you’ve already opened. The closest thing that resembles this in the real world is insurance.
When you make a long term investment, be it in a house, or in a large position buying the EUR/USD you have certain expectations. The house to last a lifetime and the euro to climb its way to new highs. 1.50 will do nicely for me.
After you make these assumptions and invest in them, you need to consider the possibility you might be wrong about them. It’s the mark of maturity to anticipate our own capacity to make mistakes and this is where the hedge (or otherwise called insurance) comes into play. In trading its done by opening an opposite trade/position to limit the risk of another trade/position, insurance is it’s closest equivalent in the real world.
For your house, you take out an insurance against fire, natural disasters, theft etc. For the EUR/USD we use the hedging functionality.
For instance, right after we buy the EUR/USD, there might be a move down which rattles your confidence in the prediction you made. So you open a position selling the euro, as it obviously has some way to go down (as seen on the picture below). Although this is done as a consequence of the first trade, it’s an altogether new one – both will be displayed clearly as two separate orders, each with their own timestamp, entry level and profit/loss. Now instead of just registering a loss from the first trade, you can have some upside while you wait for it to happen.
In the above examples you can see how the hedging mode gives you an advantage after the price goes in the opposite direction of your trade. In both cases we start off with a “buy”, but the price goes down. If you have a stop loss level, it gets triggered at level “B”, but if you have the option to hedge, you can actually “sell” at level “B”. With this you can make a profit until the price runs down to level “C”, from where, hopefully there is an upturn and potential profit from your initial order.
The hedging functionality is also handy when trading the same asset at different timeframes. For instance, you may think GBP/USD is going down in the next days and possibly weeks (by looking at its weekly chart) and you sell it with an amount reflecting your confidence in the trade (we recommend that none of your trades exceed 5% of your funds).
At the same time you see that it’s reached a technical support level (which is visible on the hourly chart below) and so you’d like to buy it for a shorter period, before any other factors continue to press it downwards. To take advantage of this you open a second trade, buying GBP/USD. Besides a possible short-term profit, such trades can also act as a platform for when the daily trend finally reverses.
The infamous hedge funds became popular by their pinpoint accuracy in defining the most important components of hedging – timing and size. Miss the moment and it might be pointless to hedge altogether, or the downside might actually grow. Hedging the wrong amount, on the other hand, may make the move ineffective or too risky.
Mastering hedging should first be practised and then used in real accounts, as all the mentioned variables can quickly change. But once you add it to your abilities, it can smooth out the dips in your performance, or even be a life saver when something goes awry.
There will be some changes when trading in hedging mode when it comes to auto-close orders, the main types of pending orders and for trailing stops. You can check them out here, where you’ll also find where they will be placed.
We’ve also prepared a video tutorial on how to use the hedging function. Among the technicalities you’ll notice the “netting” function. This is one of the important functions we’re adding alongside and within hedging, as it allows you to merge your separate positions into one if you choose to do so, with the added benefit of being saved the spread for each of them.
If you have any questions about the hedging mode, or the principles guiding its use, let us know in the comments section and we’ll get back to you.