Hedging in the Forex Spread Betting Market
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While many spread betting account holders have yet to make use of hedging, it is a useful technique to learn when trading in the currency markets.
Having said that, there are a few things that you should be aware of before attempting to apply it to your own trading activities.
In the first place, hedging is not a way to make money; in fact if you use hedging too much you might actually diminish your profits in the long run. Hedging is a way to minimise losses; note that the term used is 'minimise losses' rather than eliminate them.
Secondly, hedging does not come without a cost. Every hedging trade has an associated cost in terms of the spread and the stop loss if the price goes in the opposite direction.
One of the most common uses of hedging in the forex spread betting market is where an exporter wants to protect themselves against potential negative movements of a currency.
Let us say, for example, that you are a farmer exporting vegetables to the US market. You might be concerned that the value of the US dollar will decline during the period between the planting season and the time that you are ready to sell the produce.
In this case, hedging would imply going short on the US dollar and long on your local currency for an amount equal to the estimated value of your harvest.
If the US dollar should be in decline during the period in question, you will lose money on the produce you sell, but will make a similar amount on the hedging investment.
The cost comes in if the value of the US dollar should actually strengthen. In this case you will make additional money on the value of your exports, but lose a similar amount on your hedging investment, unless you close it before it reaches that stage.
Hedging in the Forex Spread Betting Market
Hedging is often compared to a form of insurance because traders often make use of derivatives instead of the full priced trading instrument.
In the FX spread betting market this can mean that you could buy the protection of a hedge trade at an initial cost of much less capital than the amount you want to insure against.
Always be aware that leveraged investment formats carry a high level of risk and it is possible to lose more than your initial investment. Ensure you fully understand the risks and seek independent financial advice if necessary.
Hedging in the Forex Spread Betting Market: Using Multiple Currencies
If you are invested in the EUR/USD, you could of course go short for the same amount on the same currency pair.
While that might protect you against any possible losses, it will also mean that you cannot make any profit.
An alternative approach is to go short on a related currency pair, such as the GBP/USD. If one goes against you, you will most likely make money on the other currency pair.
Hedging in the Forex Spread Betting Market: Closing a Hedge Trade
Knowing when to close a hedge trade is as important, if not more important, than knowing when to start one.
If the main trade actually goes in your favour, there comes a time when you should let go of the hedge. Failure to do that would, of course, mean that you forfeit any possibility of making a profit on the main trade.
In a sense, the problem is very similar to dealing with a stop loss; in an attempt to protect yourself against losses, you could actually end up wiping out your profits.
A general rule that some trades make use of is illustrated in the EUR/GBP chart below.
For example you may want to go short of the EUR/GBP spread betting market at the 'start' point, because you believe the price will turn around and head south, but you also want to protect yourself against possible losses.
In this case you could enter into a simultaneous long trade on a similar currency pair. If the main trade goes against you, you would have less to worry about because the hedge will protect you.
If, on the other hand, the trade goes the way you hope, then you will have to decide when to close the hedge trade.
The point marked ‘stop’ in the chart is one sensible moment to exit. This is where the EUR/GBP price has shown a clear break below the Ichimoku cloud.
Hedging in the Forex Spread Betting Market: Rollover Trades
While this is strictly speaking not what we traditionally mean by hedging, some traders believe it is possible to make money by using rollover trades.
This involves going long overnight on a specific currency pair with one broker who does charge and pay interest on overnight positions and then going short on the same currency pair with a broker who does not pay or charge interest.
While the net profit/loss on the trades should be zero, the trader can make a profit equal to the overnight interest he or she receives.
Good luck and happy trading
Shai Heffetz, InterTrader
(Original article written 28 March 2011).
Spread betting carries a high level of risk and you can lose more than your initial deposit, so you should ensure spread betting meets your investment objectives.
The contents of this report are for information purposes only. It is not intended as a recommendation to trade. Neither InterTrader nor CleanFinancial.com accept any responsibility for any use that may be made of the above or for the correctness or accuracy of the information provided.
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'Hedging in the Forex Spread Betting Market' edited by DB, updated 28-Mar-12
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