Hedging in trading: A practical guide to managing market risk
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Markets are unpredictable—that’s what every trader will have to realise at one point in their trading experience. While no one can completely eliminate market risk, there are strategies stashed in one’s trading war chest that can help reduce its impact. Hedging is one such strategy.
What is hedging in trading?
You might have heard of it in the context of investment and multinational corporations, but hedging is also a concept that is relevant to individual traders. In trading, hedging is a risk management strategy that reduces the potential losses of an existing investment or any trading position. Instead of setting one’s eyes on maximum profit, a trader hedges in order to reduce potential capital losses. Knowing how hedging works can help you make more informed decisions when markets become volatile.
If a trader holds a position that could devalue under certain market conditions, he can open another position that may increase value if and when that scenario occurs. The profit from the hedge may offset some of the losses incurred on the initial trade. For example, a trader with a long position in a stock index may open a short CFD position on the same or a related index if the market weakens. If the market falls, the gains from the short position may compensate for losses on the long investment.
You can think of hedging as some sort of insurance, a risk transference approach. Insurance may not preclude one from getting into an accident, but it helps reduce the financial burden coming from it.
Common hedging strategies
There is no single hedging strategy that suits every trader. The right approach mainly depends on your objectives and the assets you trade.
Direct hedging
The trader opens an equal or offsetting position in the opposite direction on the same underlying asset like for example the EUR/USD pair. The trader opens an opposite position on the same asset. While this is a hedging strategy, we recommend checking first the rules that apply to one’s trading account as some account types and jurisdictions restrict direct hedging.
Correlated asset hedging
Some markets are correlated with one another: for example, the gold and the US dollar, or airline shares and oil price movements Whether the correlation is strong or weak, traders sometimes use their relationship when constructing a hedge.
In correlated asset hedging, rather than hedging with the same asset, a trader uses another instrument that has historically shown a strong correlation with the original asset. The caveat with this approach is that sometimes correlations between assets can weaken over time.
Currency hedging
Currency hedging helps protect investments from sudden movements in exchange rates. Suppose an Australian investor owns shares that are listed in the United States. Even if the value of those shares increases, changes in the AUD/USD exchange rate could reduce returns when converted back to Australian dollars.
To manage this risk, traders use a related currency position designed to offset the effects of those fluctuations. The primary aim of currency hedging is to manage foreign exchange risk rather than generate additional returns.
However, hedging does not guarantee investment returns. It can reduce the impact of currency movements, but the underlying investment can still gain or lose value, while the hedge itself may involve costs and other risks.
Portfolio hedging
One of the more advanced trading risk strategies, portfolio hedging works by investing in assets that tend to move in the opposite direction of one’s main holdings, so that if one part of a trader’s portfolio declines, the other may hold or gain, offsetting some of the losses. Some traders and investors use derivative instruments like options or futures contracts to manage risk and reduce potential losses during periods of market uncertainty.
Hedging using CFDs
Contracts for Difference (CFDs) can be used for hedging because they allow traders flexibility of taking both long and short positions without owning the underlying asset. This same flexibility affords traders to respond with greater agility under changing market conditions.
Same drill for other assets: a trader holding physical gold may use a short gold CFD position if he expects prices to fall over the short term. If gold prices decline, gains from that CFD position can partially offset losses on the physical investment. However, as with all leveraged products, CFDs carry significant risk. Traders have to weigh all the pros and cons as both profits and losses can be magnified.
The pros of hedging
Hedging offers several benefits, if and when used appropriately:
- Risk reduction: While no strategy can eliminate losses entirely, hedging is an effective way to limit the impact of adverse price movements by reducing exposure to certain market risks.
- Potential protection from market volatility: Hedging allows traders to maintain long-term positions even amid short-term periods of uncertainty. Traders may rush to exit an investment because of the temporary volatility. With hedging, they can remain invested while managing downside exposure.
- Flexibility: Markets don’t always move in the same direction, so hedging provides traders with ways to adjust their exposure to changing conditions without abandoning their broader investment strategy plan.
- Potentially less emotional decision-making: Knowing that downside risk has been partially managed may make it easier to stick to a well-defined trading plan instead of reacting on impulse to sharp market swings.
When should you start hedging?
No one can know for sure, but many traders focus first on learning recognised risk management techniques, such as position sizing, stop-loss orders, and portfolio diversification before they start hedging.
Hedging is generally useful when a trader already has exposure they wish to protect. Rather than replacing risk management, hedging can complement a trader’s trading strategy. Before implementing a hedge, traders should understand why they are opening an additional position, how that relates to their original position, and under what circumstances they intend to lift the hedge.
Hedge using CFDs with FP Markets
Looking to build a more comprehensive risk management strategy? FP Markets allows you access to a range of global markets, including forex, shares, commodities, and CFDs through modern trading platforms. You can build your first trading plan, or you can use CFDs to implement more sophisticated techniques like hedging. Either way, you can have tools, market access and educational resources to help you become a trader with goals in no time. Open an account today and explore opportunities across financial markets, while managing risk intelligently.
Frequently asked questions (FAQs)
Hedging is a risk management strategy that helps reduce potential losses by opening a second position that may offset losses on an existing trade if the market moves against you.
Hedging is generally better suited to traders who already understand basic risk management, including position sizing, stop-loss orders, and portfolio diversification.
Yes. CFDs can be used to hedge existing positions because they allow traders to take both long and short positions without owning the underlying asset. However, CFDs are leveraged products and involve significant risk.
