The term “Hedging” has been so misused over the years that most traders today don’t know its real definition. The word hedge is defined as “a way of protecting oneself from future financial losses or adverse circumstances”. In trading, it is meant to be a way for importers, exporters, and farmers to protect the value of their physical goods from future price fluctuations. This is how futures exchanges were first established. An importer/exporter would purchase a contract worth the value of the goods they were buying/selling in order to protect any change in that value.
In FX trading, this term has now become synonymous with a simple and useless strategy- to hold a Buy and Sell position of the same instrument at the same time. I should clarify, in RETAIL FX trading, this is what Hedging has become. In the institutional world of FX, where banks trade with each other, there is no such thing as Hedging. When you Buy 100k EURUSD, in order to close your order, you must Sell 100k EURUSD. In other words, putting in a sell order simply closes your original buy order.
However over the years, traders have demanded that they be able to open both BUY and SELL positions at the same time. You may ask “Why would anyone want to do that?” The answer 99% of the time is because the original order is floating a loss and the trader doesn’t want to realize that loss. They would rather open a position in the opposite direction, and essentially get stuck with a floating and unrealized loss. Eventually the goal is to predict the bottom of the original loss, close out the “Hedged” trade, and ride the original trade back into profitability. What a great idea!
The sad truth is that this almost never works as this requires the trader to be able to pick the “top or bottom” of a trade. If traders were really able to do this, why not simply close the trade and reopen at where the top or bottom would be?
For example, if a trader goes long EURUSD @ 1.1230 and the price moves to 1.1200, they may decide to open a short position to protect further losses. In reality, they are stuck with a position floating a 30 pip loss. But in the traders mind, he thinks the price will drop further to 1.1150 so he wants to earn on the short position.
Now let’s say the price does exactly what the trader wants. It falls to 1.1150 and then rises back to 1.1230. They get out of their short position at 1.1150, profit 50 pips, and then break even on the long position, earning a total of 50 pips. This would require tremendous luck and skill in order to pick the exact top and bottom of the trade but in the trader’s mind, it is the most optimal situation.
However, the most optimal situation would be to close the original long position at 1.1200 and take the 30 pip loss. Why? Because if the trader knows the price will fall to 1.1150, they would open a short position, gain 50 pips, and then open another long position back up to 1.1230, gaining another 80 pips. Net gain would be 100 pips.
Most traders will admit they won’t have the skill to do that. So why are they hedging? The answer is simple: trading psychology. Traders fear to realize their losses. If a trader really believes a position will turn back in their favor or move in the direction they want, there is no harm in cutting your losses and reentering the same position again. The effect is the same. The challenge is to get over that fear and not to fall into the trap of common mistakes traders make of letting your losses run.
The bottom line: “Hedging” your positions have no positive effect on your results. It’ll simply make you feel temporarily better like some kind of trading drug. In the end, only one party benefits from this strategy- the broker. They’re happy to collect spreads twice.