By: Terry Allen

You can reduce your risk exposure when trading Forex if you learn and utilize the concepts of hedging. Many novices shy away from this subject because it appears to be complex at first sight. However, many professional Forex traders use it successfully to increase their profits and optimize the protection for their account balances.

How can you best use hedging to improve your Forex trading? Whenever you open new positions, you will always be concerned that price will move against you. You can use a stop as your ultimate protection against a serious reversal, but you could also deploy hedging as another more subtle means of reducing your risk exposure.

When you already have a position opened, hedging involves you activating a second trade with a different, but related, currency pair. The central concept is that should one go negative, then you should still be able to profit from the second one to some degree or other. Fundamentally, if you utilize this approach, then you are using currency correlation to help you hedge your trades.

For instance, if you buy the EUR/USD, then you could consider buying the USD/YEN. Consequently, if the USD increased in value, then your EUR/USD position could have some protection because you would profit from the USD/YEN rising. Hedging can be a powerful technique for protecting your entire account from the dangers of margin calls, which occur when your equity cannot support your open positions any further.

Many successful traders incorporate hedging into their trading strategies because it can provide their trades with breathing space to achieve their objectives. This technique can protect from unexpected price movements that could knock out your recently opened positions.

However, you must beware of a number of problems when using hedging. For instance, if you did decide to buy both the EUR/USD and the USD/YEN, then you would provide yourself protection against whether the USD rose or fell in value. However, you still be at risk should the EUR depreciate and the YEN appreciate against the USD.

You could attempt to solve this problem by opening a third position to sell the EUR/YEN. You would then have complete coverage from using hedging that will provide you with full protection against any movements of the three currency pairs.

However, you will deduce from this example that one of the problems with hedging is that it can become very complicated. In addition, you must not forget that you should use hedging primarily to help you mitigate your risks because it is not designed to generate large profits.

The main advantage of hedging is that it provides you will additional time for your trades to work. Quite often, you will open a trade, which is stopped out shortly afterwards. You could then just watch in frustration as you witness price reverse and proceed back in your originally chosen direction for some extended period.

Normal stops can be too rigid sometimes and hedging could provide you with a more sophisticated method of protection.