What is hedging?
Hedging is a key concept in trading that can help to secure profits or limit losses. It's important to hedge correctly, otherwise you can end up needlessly losing more money. Here's everything you need to know about it including what hedging is and how to hedge your trades effectively.
- What is hedging?
- Why hedge a position?
- Example of hedging
- Which markets can I hedge?
- Advantages of hedging
- Disadvantages of hedging
- How to hedge a trade
1. What is hedging?
Hedging in trading is where you open a position that goes against a current open position. So, if you have an open long position on Apple, and then wish to short Apple as you believe its price will fall, you can then hedge Apple by opening a new short position. Both positions will then be open simultaneously.
Many brokers and those offering trades on positions will hedge themselves as a way to manage their own risk and ensure losses are covered. For example, if a broker accepts a short trade of £5 point on Apple, if Apple's price fell 5,000 points (something that's unlikely but certainly could happen), the broker will lose £25,000 – not including spread.
That's not too damaging, but if multiple traders open similar positions, the exposure will be large enough to severely impact the broker. Therefore, the broker will have to place a short trade themselves on Apple, so that if its price does fall the broker won't lose out and can cover the costs.
2. Why hedge a position?
There are two main reasons why you as a trader would hedge a position. These are:
- Protecting profit
- Short-term gains
If a position is profitable, to protect the positive PnL you can open a hedge and effectively add a second position in the opposite direction. This means that should the market turn against the initial trade and make it non-profitable, profit will be earned from the hedge trade. Loss will be incurred from the initial trade, but less will be lost than if the hedge was not placed.
In the short term, a price market might be moving against your trade. Say you opened a long trade on Apple, but its price is falling drastically following a weak earnings report. You might believe Apple will recover and be profitable in the future, so want to leave your initial trade open, but at the same time want to take advantage of the price fall in the short term. Hedging enables you to keep your long-term trade open while opening a new position that looks to take a profit in the short term.
3. Example of hedging
A long (buy) position is opened at £1 a point on Bitcoin at a price of 5,000. Bitcoin's price then rises to 6,000, so the PnL on the trade will be £1,000. At that point, a hedge would be to open a short (sell) position at £0.50 a point on Bitcoin, so that if the price falls money will be lost on the initial position but it will be made back on the new position that has been opened at a price of 6,000.
The amount hedged is usually greater or less than the opposite position's value. A hedge position can be opened at the same value as the initial trade if you're simply looking to withstand a period of volatility, but in the long term this is redundant. The PnL will not change as a move in price in either direction will cancel itself out - so you might as well just close the position all together.
If a trader has a suspicion that Bitcoin's price will continue to rise, but just wants to protect a proportion on their equity, a hedge position at £0.50 a point could be opened on Bitcoin at a price of 6,000. This will mean that should Bitcoin continue to rise, the PnL of both positions combined will show profit, but also if the market were to turn, the trader wouldn't lose their full investment on the long position – or rather they would, but the loss will be partially countered by the short position.
A long position is opened at £1 a point on Bitcoin at a price of 1,000. Bitcoin's price then rises to 5,000, so at that point the trader has a profit of £4,000. However, a major corporation then comes out and publicly denounces Bitcoin causing its price to quickly fall down to 4,500. The price shows no signs of stagnating, and further losses seem likely. The trader may feel that Bitcoin is going to be successful in the long run, but equally doesn't want to miss out on the short-term opportunity.
Therefore, a new short position is opened on Bitcoin at a price of 4,500, purely with the intention of capitalising on any further short-term losses. Were Bitcoin to fall lower (as expected) to 4,000, the profit on the hedged short position will rise while the profit on the long position falls. The short position can then be closed, taking the profit, while the long position is kept open in the hope that its price will recover and rise back above 5,000.
4. Which markets can I hedge?
With many brokers, hedging a market is not possible. If you would want to alter the trade, you would have to close the existing one and open a new one in the opposite direction.
ETX, however, offers a number of markets that can be hedged simultaneously.
Some of the markets you can hedge with ETX Capital are:
- SP 500
- Wall Street
- UK 100
5. Advantages of hedging
Should the market turn against a position that you have hedged, the hedge position will cover some of the loss and ensure you don't lose 100% of your equity of the initial trade.
Relive stress and pressure
With a proportion of the exposure from the initial trade hedged, less will be lost so there's less worry about the market going against you.
Profit that is already earnt with the market rising can be secured by hedging the position.
Allows greater exposure
If the risk is mitigated through hedging, it can allow you to increase the exposure for a trade safe in the knowledge that if the markets don't act in your favour, not all of your funds will be lost.
Allows you to withstand volatility
Periods of volatility and extreme fluctuation that might normally force you out of the markets can be countered with hedge trades that can help to secure a position and combat the volatility.
Where you might have to regularly track an open position in case its price changes, hedging means that even if it did you wouldn't necessarily need to close, open or make any changes to the trades.
Short and long-term gains simultaneously
If you have a long-term position open on a market but want to take advantage of short-term price movement that is acting against that long-term trade, hedging allows two contradictory trades to be open at once. You can consequently take advantage of a price movement in either direction on the market with two open trades simultaneously.
6. Disadvantages of hedging
Eats into profits
If a market moves in favour of an open position that is hedged, the hedge trade only cuts into profits and is mitigating risk that hasn't come to fruition.
Lose more from spread
As hedging requires a second position to be opened, a spread is taken from both trades. This means that if the market does not move, the hedge trade is not needed and more spread is lost. In essence, although there's no direct cost of hedging with ETX, the spread means that you will lose money were the market not to move.
Not beneficial to short-term strategies
With markets moving heavily from day to day, hedging can be a difficult strategy to master for day traders.
7. How to hedge a trade
Hedging on our award-winning TraderPro platform is simple. To hedge an open position:
1. Identify the market you wish to hedge.
2. Select the hedge market - e.g. ‘GBP/USD (hedge)'
3. Determine how much you want you hedge trade to be
4. Open a trade as normal
Once the hedge trade is open, it acts as any other regular trade. Anything you do to the hedge trade won't affect the initial position and vice versa. They act as two entirely separate trades on the same market.