Is It Really Any Help On Forex Hedge Trading ?

Some Forex retail traders after incurring significant losses on equity trades try later to hedge against any further losses. On the surface it appears to be a good strategy to minimize losses. But in many such instances a policy of hedging fails to help. In this article, we would try to see how it happens.

What Exactly is Hedging?

Hedging in trades with purely financial implications is comparable to taking insurance policies against loss of inventories and properties from fire, or to cover loss of earning capacity due to unexpected injury, sickness or death.

To explain the concept of hedging further, let us take an example of a currency trade. Suppose you trade long on EUR/USD at a rate of 1.4595 and suddenly the rate plummets to 1.4565 incurring you a loss of 30 pips. So you enter into another contract to cover yourself against such further losses, shorting at the current market rate of 1.4565. By doing so you ensure that you will not lose anymore even if the rate falls by a further 10 pips to 1.4555. In this scenario, you would lose 10 pips on your first long trade and gain 10 pips on your subsequent short trade thus neutralizing each other to leave you in a no loss/no win position.

The Hidden Implications of This Type of Hedging:

At a glance, hedging appears to be a bright idea; which is the impression that inexperienced traders invariably get. It would appear that hedging effectively shields the investor from incurring further losses, while there is also the possibility of the rate to readjust in his favor in the meantime. This is the precise misconception that leads many investors to misguidedly fall into a trap of contracting such hedging trades.

The Problem of This Type of Hedging Unraveled:

Assume that the price turns around to the original level of 1.4595. Still you could be losing 30 pips! How?

To start with, you went long at 1.4595, (the current price prevailing then), which makes you to breakeven. But your subsequent short trade that you entered at 1.4565 would be incurring you an unrealizable loss of 30 pips. So, on the latest position, while you breakeven on your first long trade, you make an unrealizable loss of 30 pips on your second short trade, giving you a net loss of 30 pips on the whole. That is in addition to the extra transaction fees etc. you incurred on your bid/ask spread on the hedge.

Had you not entered into the second trade as a hedge, you would now enjoy a breakeven, no loss/no win position with prospects of earning profits, if the upward trend of the Euro continues. On the other hand you will incur further unrealizable losses as the Euro price rises as things stand now due to the second trade that was done as a hedge against possible losses on your initial long trade.

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