What is hedging in trading Strategies, benefits & drawbacks
What is hedging in trading? Strategies, benefits & drawbacks
The goal of hedging is to eliminate the volatility linked to an asset’s price by taking offsetting
positions that are contrary to the investor’s current positions. This is done to safeguard
against possible capital losses.
Using a hedging strategy, a trader may choose to open a long and short position on the same
or similar financial instrument to mitigate exposure to a specific economic announcement or
event. In other words, a long position in one trading instrument and a short position in
another positively correlated instrument are opened simultaneously just before the release
of significant financial data or other key events. Both positions remain open without offsetting
each other, until the one benefiting from the initial market reaction is closed to secure gains.
The second position is then held as the market corrects itself, and it is closed once the
correction is complete.
In the case of forex trading, a hedge trader might open a trade on a correlating currency pair
to protect against potential losses. For instance, if a trader has a bullish position (i.e. gone
long) in GBP/USD and seeks to limit potential losses, they might enter a bearish position (i.e.
go short) in a different currency pair that usually moves in a similar direction as GBP/USD.
An experienced trader could employ this approach to profit from both ends of their hedged
position. However, its success hinges heavily on the magnitude of the post-event movements
and the ability to exit at the opportune time, which often requires a significant amount of
discretion.
Potential drawbacks of the hedging strategy
- Some brokers do not accept the strategy, considering it an abuse of the system.
- The strategy requires market volatility; without it, profits could be minimal.
- The correction after the initial market reaction may not be sufficient for the second
trade to be profitable, limiting the gains of the first trade. - The strategy requires careful judgment and precision from the trader.
- Brokers often widen spreads significantly during high volatility, increasing trading
costs.
Positive aspects of the hedging strategy
- Seeks to shield investments from unfavourable price movements like adverse
economic events. - Helps to minimise potential losses by balancing positions.
- The strategy can be applied to different asset classes, e.g. currencies, metals,
commodities, stocks, etc.