Definition of Hedging
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What is Hedging?
Hedging is a trading technique consisting of partially or entirely covering the price risk on a product. If your position is 100% hedged, your risk is zero but in return you cannot generate gains. Hedging is practised on all types of markets (Stock Exchange, Forex and Commodities) but can be done on different types of products. The objective of hedging is to not expose your capital to market risk when you have doubts about future movements. This technique can also allow you to take advantage of movements in the opposite direction to your initial trade.
How to hedge your position?
Hedging allows you to hedge against price fluctuations. Depending on the market you are trading in, the method for hedging your position will be different:
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Hedging on Forex
: This is the simplest market for hedging. Simply place an order in the opposite direction to your original trade for the same position amount. If you are buying you should open a position for sale or vice versa on the same product. Your risk is zero. You can also partially hedge your position but you will still be exposed to market risk (to a lesser extent). Hedging your position is carried out directly from your trading platform but be careful, not all platforms allow you to hedge your positions. You should therefore check with your Forex broker beforehand.-
Hedging on the Stock Exchange (shares/indexes)
: There are several possibilities for hedging a position on shares:-
Hedging with options
: If you are bullish in the market, you can take out a Put option to hedge against the downside risk. If you are bearish in the market, you can take out a Call option to cover your upside risk. For adequate coverage, you need some financial knowledge. Therefore, be careful, and learn as much as you can about hedging with options.-
Hedging with the French Deferred Settlement Service or SRD
: The SRD (Service de Règlement Différé) allows you to take a downward position on stocks. If you are bullish on the markets, you can therefore hedge all or part of your risk by taking a downward position on the SRD. Please note, however, that not all securities are eligible for the SRD.-
Hedging with CFDs
: This is the hedging technique I recommend to cover your positions on the equity markets. The operation of CFDs is simple and transaction costs are very low (you only pay the spread). In addition, it only takes up a small portion of your capital to cover your positions since you have access to leverage. Finally, a very large number of products are available, you just need to find the right CFD broker.Why hedge your position?
Hedging allows you to fully or partially cover your risk with the aim of:
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Taking advantage of correction movements
: Hedging is of no interest to scalpers. For swing tradershedging can help you earn more.Let’s look at an example: You have been long on the EUR/USD (see the EUR/USD analyses) since it was 1.1350. The pair currently odds at 1.1370 and you are targeting 1.14. Problem, you anticipate a correction movement that could lead the EUR/USD to pullback on 1.1350. Instead of suffering the correction movement, you could therefore decide to cover your entire position at 1.1370 and therefore take a short.
You are then flat on the EUR/USD. At this precise moment, your exposure to risk is nil. If the correction occurs, you can then decide to cut your short position (your hedge) once the correction is finished. If the price starts to rise again, then you will have managed to benefit from both the main trend movement and the correction movement. If the decline continues, you are again exposed to risk with your long position.
The risk in using hedging in this way is to deprive yourself of potential gains if the movement, in the direction of your initial trade, continues without any correction. Using hedging for this purpose can mean that you earn more but it can also cause you to lose money. Therefore, hedging strategies should not be abused. Wanting to capture all price movements is utopian.
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Protect some of your earnings
: Hedging can be used if you have doubts about the movement continuing in the direction of your initial trade. This may be the case when there is important economic news or a key level.Let’s look at an example: You have been trading long on the EUR/USD since it was 1.1350. The price approaches 1.14 but you identify significant resistance at this level. You are then in profit by nearly 50 pips. Additionally, important news is about to be published (see, trading on economic announcements). Therefore nothing is clear, it is impossible to know in which direction the price will start moving. If you do not take your winnings before then you risk losing all or part of your profits.
You could then decide to hedge just one part of your position to glean additional information. Hedging is then a phase of waiting, gathering new information and analysis. The part of your position that is hedged is then secured, you cannot lose it. However, with the part of your position that is not hedged, you are exposed to risk. If the movement continues in the direction of your initial trade, you generate additional gains. If the movement goes the other way, you lose some of your gains on the unhedged position but you keep all of your gains on the hedged position.
By using hedging in this way, you limit your expectation of gains but in return you also reduce part of your risk.
