What is Forex Hedge?
Hedging is when a trade is placed by a forex trader to protect an existing or losing trade. It is carried out in forex trading to protect one’s position from a sudden currency price move in the forex market.
Hedging involves, placing both long and short positions (buy and sell trades) on a currency pair especially when the market price consolidates ( when there is no market price trend). Short-term trades or hedge trades are placed to protect long-term trades from market volatility or imbalance.
Experienced traders use Forex Hedge to limit their risk. It is used to close a losing trade in profit (here, the lot size of the hedge trade is increased). For a take profit move of 100 to 150 pips, a Recovery Zone (of 30 to 50 pips, depending on the trader choice) is allowed between the long-term trade and the hedge trade(s).
Prolonged consolidation of market price is a major disadvantage of hedging as a large capital is required for the trader to sustain the increasing number of hedge trades that are being placed to close the first trade in profit.
The uncertainty of market price direction is the main reason for forex hedge.
The diagram below shows three trades 1, 2 and 3. Trade 1 is the main trade while trades 2 is the hedge trade that will protect trade 1 from loss. Trade 3 will also protect hedge trade 2 just in case consolidation continues.
A trader places trade 1 with a take profit of 150 pips and 1 lot as the lot size, at the same time he places trade 2 (hedge trade/protection trade) at a distance of 50 pips away from trade 1. Take profit of Trade 2 will also be 150 pips.
Stop loss of trade 1 will be 200 pips (which is Recovery zone distance plus take profit of hedge trade). If trade 2 does not trip take profit but returns to the direction of trade 1, then another hedge trade 3 of 1 lot size will be placed to protect trade 2. Take profit of each trades will be 150 pips while stop loss will be 200 pips.
FOREX HEDGE-ZONE RECOVERY
Zone recovery is a hedge trade pip distance that you put into consideration when you want to place a hedge trade (especially when your scalp trade is running to loss).
50 pips zone recovery should be considered when you place a wrong scalp trade and market start to go against your trade.
Instead of placing stop-loss, you should activate hedge trade (counter trade). (It will take more effort and time to recover already lost pips in case of stop-loss).
Example: If you scalp buy at 1.1750, and market start to sell strongly against your scalp, (possibly due to sudden high impact news release), the recommended zone recovery should be at 50 pips loss area.
The implication is, instead of placing stop-loss at 1.1700 (50 pips loss area), You should rather place a SELL trade at 1.1700. The SELL trade is your hedge trade to temporarily halt your trading account loss.
However, activating hedge trade at 50 pips zone recovery is in anticipation that market will continue to sell, and this is when you must be at alert on your hedge trade to avoid being caught in a trap at both ends.
Please do not forget this: When you place a hedge trade, you must be at 100% attention, should in case a long spike (price rejection) shows up on the 1 hr or 4 hr time frames (indicating that price is heading back to the initial direction – that is, price start to buy again).
Do not hedge and then, go to bed. Else, if you do not have time to check on your hedge trade regularly, don’t hedge at all. Just place a stop-loss and move on if you know you can’t monitor your hedge trade.
Your zone recovery should be 50 pips loss, always have this in mind!
Hedging Without Increased Lot Size
Now, we have two possibilities for my hedge trade in the image above.
If price continues to point C, (say, at 1.1745 resistance area) then sell trade at A will be in -78 pips loss. While placing hedge trade at B, the counter-trade will be in 28 pips profit).
Money management recommendation is, use maximum lot size of 0.02 for a $100 trading account.
When price gets to point C, sell trade loss will be -$7.8 while profit for the hedge trade will be +$2.8 for 0.01 lot size, in either direction.
When price is at point C, place a stop-loss in profit at 1.17173 level (1 pip profit level on hedge trade), and keep an eye on the hedge trade for a possible price rejection (Spike) at point C, (where we have the 1.1745 major resistance area)
If there is no reversal at point C, and price continues up, (that is, breaks the major resistance level at 1.1745 area) then allow the hedge trade run till a major reversal commences at the next higher resistance level, say 1.1822 level.
You may leave the 1 pip profit on the hedge trade and place stop-loss at the 1.17173 level, (if you want to), as long as the there is a big spike at the top indicating that price may retrace soon.
Or you may close the +$2.8 profit at the point C (1.1745 area), knowing that at this area is a solid resistance level and that reversal is certain to occur at that level.
Immediately price test and activated the hedge trade, and it reverses instantly to point D where the original sell trade is at 1.16663 area. Meaning, the trades are trapped at both ends on a 50 pips loss which is -$5 using 0.01 lot.
Just before price gets to point D, take profit on the sell trade should be adjusted on the sell trade A at 1.16653, (1 pip profit).
By doing this action, it is expected that price will continue to range/consolidate, and that it will close the sell trade at point A and reverse to point B where the hedge trade is waiting.
But, what if price continues lower, below point A or D?
Another sell order will be placed at 1.16563 which is 9 pips lower than the take profit level for the initial closed sell trade at 1.16653.
(Summary: Losing trades/funds affect traders’ zeal in forex world. However, knowing that you can manipulate the game so that you don’t lose at all, gives some level of hope. The aim is of hedging is to break even, or make profit.
No sleeping, when you activate hedge on a live account. Activating hedge trade is like compared to working round the clock without sleep. You must remain focused, and close hedge trade in profit as soon as you sight a big spike on your hedge trade.)
AUDJPY Hedged Trade – @ 50 pips zone recovery (all trades closed after Hedge Trade 2).
EURGBP Hedged Trade – @ 40 pips zone recovery (all trades closed after Hedge Trade 1).