How do hedges work actually?

Hi traders,

I have a question that I would really like answered. How do hedges work and how do you find what to hedge?

I'm curios because often, trades will go against you. So what I end up doing is hedging on the same pair. In theory, all you need to do is find the right time to unhedge and you will start making money. So that initial mistake is not too much of a liability.

The problem is: if you know when to unhedge, you wouldn't be in this situation in the first place (because you need to be able to determine where the price is headed)

I know hedges work. People all over the world use it to manage risks. But how does it work? And how do you qualify a pair (or multiple pairs) to hedge? more importantly, how do you use it to make money?

Can any experienced traders educate me please?

They don't hedge w/ the same instrument. Like an oil refinery would hedge it's oil cost by buying oil "call" options if it thought price was going up.

If price didn't go up it wouldn't exercise the option, if price does go up then it does and saves the difference. Because option costs are a premium (fraction of the original instrument cost tacked on top), costs are easily managed.

There is absolutely NO benefit to buying and selling the same security at the same time for a hedge. Altho there is some benefit to "trading around" a position. Ie: holding a long term position and trading short term trades (which may or may not be the opposite direction) around it. The latter appears like a hedge to an untrained observer, but it's function is very different.

so are you sayong that you cant hedge in forex?

Sure you can, just don't use 2 spot currencies. Using the same instrument to hedge itself is the easiest way to trade against yourself.

In finance, a hedge is a position established in one market in an attempt to offset exposure to the price risk of an equal but opposite obligation or position in another market — usually, but not always, in the context of one's commercial activity. Hedging is a strategy designed to minimize exposure to such business risks as a sharp contraction in demand for one's inventory, while still allowing the business to profit from producing and maintaining that inventory. A typical hedger might be a farmer with 2000 acres of unharvested wheat in the ground, who would rather tend his crop without the distraction of uncertain prices. He's a farmer, not a speculator, yet his unharvested "inventory" may have lost 35% of its value ($285,000) in the three months he's been planning his planting. He might have decided he could live with a price of only eight or nine dollars a bushel, and to offset his planted position with an approximately equal but opposite position in the market for wheat on the Minneapolis Grain Exchange by selling ten wheat futures contracts for December delivery. This farmer is thereby a hedger indifferent to the movements of the market as a whole, and has reduced his price risk to the difference between the price he will receive from a local buyer at harvest time, and the price at which he will simultaneously liquidate his obligation to the Exchange. Holbrook Working, a pioneer in hedging theory, called this strategy "speculation in the basis,"[1] where the basis is the difference between today's market value of (in this example) wheat and today's value of the hedge. If that difference widens, he earns a little more at harvest time. If that difference narrows, he earns a little less. He has mitigated, but not eliminated, the risk of losing the value of his wheat as of the day he established his hedge.
Some form of risk taking is inherent to any business activity. Some risks are considered to be "natural" to specific businesses, such as the risk of oil prices increasing or decreasing is natural to oil drilling and refining firms. Other forms of risk are not wanted, but cannot be avoided without hedging. Someone who has a shop, for example, expects to face natural risks such as the risk of competition, of poor or unpopular products, and so on. The risk of the shopkeeper's inventory being destroyed by fire is unwanted, however, and can be hedged via a fire insurance contract. Not all hedges are financial instruments: a producer that exports to another country, for example, may hedge its currency risk when selling by linking its expenses to the desired currency. Banks and other financial institutions use hedging to control their asset-liability mismatches, such as the maturity matches between long, fixed-rate loans and short-term (implicitly variable-rate) deposits.
A hedger (such as a manufacturing company) is thus distinguished from an arbitrageur or speculator (such as a bank or brokerage firm) in derivative purchase behaviour.

ok, the other question is how do you use hedging to make money?

take hedge fund managers for example. they hedge themselves to limit risks and yet are able to make money. i don't understand how this works.

also, they hedge on the same instrument. eg: they can short and long a stock at the same time. i do know they short and long different stocks. but they still hedge on 1 instrument.

can the same be applied in forex trading?

Let say I think a stock is going to go up a lot. I might also buy some put options incase it goes down and I'm wrong. The question is whether you recoup the cost of the options. In otherwords options themselves convey no edge, you have to have a good strategy first. Obviously you're several light years from that at the moment.


There are currency options, but they're pretty weak at the moment. You could try gold against the US dollar perhaps, but that's creating a spread.

Frankly I don't think forex is a good market for a hedge pair, however you could buy currency options to hedge against an adverse move if you're so concerned.

If it is not possible to mitigate that risk in forex, how do professional forex traders handle their money? It cant be just simple buy/sell with stop loss. That is only trading half naked.

Where can I go to learn more strategies? Or if anyone is willing to, post here how you do it?

Why not? Control lot sizes, enter appropriately, use an appropriate stop loss. You don't need anything else. Simple is good. Either you have an edge or you don't.

Complex hedging strategies don't usually mitigate risk, they just increase it in some obscure way that's easy to forget about.

they call the direction right, but use the hedge to limit their risk. no matter what you trade, wherever you go, it is literally impossible to have a perfect hedge. in FX, even if you sell and buy the same exact currency at the same exact time, you'll still be down spread for both positions, plus negative roll will be greater than positive roll, so you'll end up with a negative position. hedge funds use things like stocks, futures, and options to hedge. like mentioned above, they use two different types of instruments.

for example, let's take a farmer who has a crop of lima beans and he thinks the price is going to drop before he sells them. he wants to hedge his crop so that if it does go down, he wont lose as much money as if he was in a hedge. so essentially, the farmer is long on his lima beans (because he has them now and plans to sell them later) this is called a cash position. in order to hedge, he is going to sell (short) lima bean futures. now, because of the difference in the positions and contract size limitations, this wont be a perfect hedge. he will still probably have a bigger exposure on his crop than on his futures contracts. let's pretend the price does go down and say that the farmer lost $15,000 on his lima beans and won $14,000 on his futures contracts. now, instead of losing 15K, he only lost 1K.

this same principle can be applied the opposite way in order to make money. if the price had actually gone UP, the farmer would have MADE 1K instead of losing it.

that is how the big funds do it. they hedge their positions so that they get either a smaller loss/win than they would on an unhedged position.

hope this helps

Right, as there is a time lag between the decision to produce soft commodities and the time at which they can go to market, this creates uncertainty for the farmer. In order to reduce risk he can take a short position to an equal value of the current market price of his expected harvest, effectively locking in todays price. If price goes down he will make less on his harvest but the futures contract will have appreciated. If price rises he'll lose on his short position but then his crop will command a greater price at market. Perhaps interesting to know but of limited use as a trader. If your account is in different demonination to the currency you use and you are uncertain about future exchange rates, you could 'lock-in' todays price by taking an equal and opposite position.

I have heard some professionals using hedges on similar (but not identical) market instruments in expectation that the values will converge at some point in the future, so they short one and long the other. As the correlationship between the two is so close, when one rises the other almost always will do too, and vice versa when market values depreciate. They are just betting on the gap between the two to close.

Long Term Capital Management were using an example of this fixed income arbitrage on government bonds, where they had indentified some discrepancies which they sought to profit from - but as the differences were so small, they were leveraged to the hilt on these positions. This wasn't a problem until it went tits up and they lost a shit load of money and needed bailing out. They had made some faulty assumptions about what could happen, thought they had all the risks sewn up in their model, completely underestimating the potential impacts of unexpected events in the market. Hedging as method of reducing risk does not necessarily work out that way.

There are perhaps some parallels to be drawn from hedging in a retail forex account if you are limited by the amount of margin your broker will offer you. Essentially your capital is being tied up when the majority of it is just acting as a counter balance to the opposite side of the hedge, which makes no difference unless your broker decides to close out the losing position to meet the margin requirements on your account. I haven't really spared that scenario much thought because I do not hedge but it is one of the main reasons that the US authorities plan to outlaw the use of hedging in retail forex, as well as the charging of unfavourable swap rates.

In short, I am yet to see how hedging can be incorporated into a profitable strategy aside from using the extremely complex arbitrage methods. More likely it is a policy employed by amateur traders who are not psychologically able to accept their losses and put the pain on hold by placing a position in the opposite direction.

Hedging might sound complicated and sophisticated and you could be forgiven for coming to the conclusion that using complicated and sophisticated approaches will lead to riches. That is not my experience - simpler the better. If you're bullish go long. If you're bearish go short. If you're not sure then stay out until you are.

Haha - very well said, and very true.

It's actually not that difficult. First though, you have to realise that trading is like running a business. You have expenses or overheads and you have income. You cant just have income. Same goes for trading. You cant always be right and just make money.

The easiest way to manage your risk is through a simple money management strategy. For example: lets say your trading account is $10 000. Now for any trade you never risk more than 2% of your trading account. $10 000 x 2% = $200 max potential loss.

That means you can be wrong 50 times in a row before you have lost all your money. If Im wrong 3 times in a row I stop trading because something is wrong! Take some time out and make sure you are in synch with the market before trading again...

good money management is probably the first and most important thing to get right. You can have the best training and experience money and time can buy, but if you dont know how to protect your capital, you got nothing. Too many new and novice traders try to replace their income from day one by risking more than what they should. Other trader's greed is what pays a big part of our salaries!

So, for those who are totally new at this this, lets say you identified a potential setup to buy. You got your stop position, entry and target: entry is at 100, stop is at 80 and your target is at 140.

That then means you can risk $10/pip ($200 / 20 pips risk = $10), you potential profit then is $10 x 40 pips reward = $400.

So basically, you cant loose more than $200 if you are wrong, and you stand to make a profit of $400. Thats a 2:1 ratio

you just dug up a 4 year old thread

which has some right and some less correct answers in, but confused me because your response doesn't have anything to do with hedging eh!

So did you! The information is stil relevant though to someone looking for answers...

I was actually trying to explain that if you have good money management you dont need to hedge. Perhaps if you are a long term trader it would be worth looking at?

See thelws post above...

But the answers are incomplete. As there is no general market risk in forex (like it is in stock market) the advice to not hedge in the same asset class seems a little bit wrong.

But I have never tried to hedge in forex and as the most traders are short term here, i dont think that it is a good idea to base a strategy on a hedge. But maybe it works...