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We have Noni here with a quick question, wants to learn a little bit more about hedging, exactly what is hedging and how trade is used to gain an edge in the market. So thanks for the question.
Now hedging generally takes a couple of different forms. I do like a recent example I heard from a trader that basically compared hedging to buying car insurance. So obviously when you buy a car insurance, you are actually just buying protection in case that you crash your car and in the same way, a hedge in trading just means that you’re buying yourself some protection in case a trade goes against you.
So let’s say you’re in a position, let’s just take the pound versus the US dollar as an example. Let’s say that you’re trading this to the downside as a swing trade, right? So you expect downside for the pound and let’s just say that you entered from this pullback area and you’re not trading this to the downside as a swing trade. Now, for whatever the fundamental reason might be. Now imagine that in the short term, something happens that creates either some dollar weakness or maybe some short term pound strength or maybe a little bit of both. So there’s some short term expectation that you might see this trade going against you.
Now, as a swing trader, you can either let the trade just play out and leave your trade as is because you’re still trading in line with the bigger picture fundamentals or you can try to buy some protection on that trade by taking a hedge. Meaning that you can take a short term buy trade on the pound versus the US dollar, or you can even hedge by actually buying a call option in the options market on the pound versus the US dollar.
Now, some traders will also look to or like to hedge themselves by increasing the exposure on other pays as well. So for example, we want to be selling the pound versus the US dollar so we have expectations for the pound to go down but we might decide to hedge, against the US dollar specifically and we can also decide to buy something like the Euro pound. So we expecting pound weakness, but we can offset the risk of the US dollar weakening as well by basically buying the Euro pound as well. So we still expecting pound weakness, but we are now hedging our risk by trading the pound against the dollar and the Euro.
Another form of hedging, in line of what we just mentioned is basket trading. So almost like we just mentioned, it’s where you… Let’s say there’s a significant sentiment shift that occurs in the market and we think there’s gonna be lots of pound downside.
Or let’s say something massive happens and there’s a year of very positive sentiment shift in the Euro to the upside. Now what some traders might like to do also as a form of hedging, but it’s called basket trading is basically to buy the Euro against a basket of the other majors. So imagine that we have that massive positive thing happening on the Euro. And now you decide not to just buy something like the Euro dollar but you buy the Euro dollar, the Euro CAD, Euro Oz, Euro Pound, Euro Kiwi, Euro Yen.
So obviously, you need to keep your risks still low, so you’re not gonna have full risk on all of them, so you reducing your risk. But the idea is that you basically diversify more hedging against a possible scenario where you trading the Euro against just one currency, and suddenly that one currency starts to strengthen against the Euro as well. So there are many ways that traders can hedge positions in the market.
But you know, just as a word of caution, this isn’t really something that you want to do without lots and lots of trading experience and understanding of how, of all the risks involved with trading this way. You know, if hedging is done right, it can really protect against any unwanted volatility swings, especially if you’re trading around a core position like a swing trade. But done incorrectly, I mean can really cause substantial, substantial damage to your account.
So it’s not really something that you’ll want to be doing as a beginner trader, obviously I don’t know where you are in your trading journey, whether you are a seasoned or a veteran trader, but if you’re a beginner, it’s definitely something that I’ll be very very careful with. And also keep in mind that some brokers might not even allow you to hedge.
So if it is something that you are looking into, make sure that your broker actually allows it in the first place. But again, even if they do allow it, this is something that you want to make sure that you fully understand how to handle and trade successfully. So I hope that helps with the question. Any other questions as always, make sure to let us know.