What is hedging and how does it work?
Hedging is a risk management strategy that involves offsetting an open trade on a security. So, you would have ‘buy’ and ‘sell’ positions open on one asset simultaneously. That way you balance out your potential profit and loss.
The advantage of hedging is that it frees up margin. With an increased margin level, you can avoid a stop-loss order, as well as make the most of short-term opportunities by opening new trades.
Take a look at the below examples.
Client 1 has employed hedging, while Client 2 has not. As a result, Client 1 has much higher free margin.
What are the risks of hedging?
Double Commissions & Swaps
When you employ hedging, you are opening two positions on the same symbol. That means you will have to pay opening commission twice, as well as double swap charges if both the positions remain open overnight.
Here’s an example. If you were to utilize hedging when trading the EUR/USD currency pair, you would be required to pay €10 for opening both ‘buy’ and ‘sell’ positions. In addition to this, there are swap charges – the swap charges for EUR/USD are -7.090159 for long (buy) trades and -2.22341 for short (sell) trades. (Pictured)
This would result in swap charges of €19.42 [(100000*0.07090159)/365] for the ‘buy’ trade and €6.09 [(100000*0.0222341)/365] for the ‘sell’ trade for each consecutive night that the positions remain open.
In other words, if you had a ‘buy’ position open on EUR/USD and decided to hedge it (open a ‘sell’ position) instead of closing it, you would commit to a one-time €10 commission fee at the opening and €6.09 swap fee on a daily basis.
Risk of Stop-Out
1) Close a hedged position while the margin level is low. By closing a hedge position, the margin used increases, the free margin and the margin level decrease. In case the margin level decrease to below 50% the client can be stopped-out immediately.
Trades: 1 Lot EUR/USD Long and 1 Lot EUR/USD Short
While the client is hedged the free margin is 1000EUR and there is no margin level.
If the client closes the short position the account will need to lock the margin for the long EUR/USD. Margin for the long EUR/USD is 3333EUR so the margin level will be 33% and the client will be going to stop-out.
2) Hedging means that your fees increase because the more positions you have open, the more fees you pay. Each time a fee is charged to your account, it decreases your equity and, as a result, your free margin.
Take a look at the below example:
If your hedged positions remain open for 1,959 days ((99,974/2)/(6.09+19.42)), a stop-loss order would be activated regardless of which direction the currency pair moves in. In the event that you have two hedged trades, the account would go to stop-out after approximately 979 day and so on.
The higher the swap charges on an instrument, the quicker the stop-loss order is activated.
For example, if the EUR/USD swaps were 60 on long and 60 on short, the swap charges would be €164 on each side. The daily swap fee for both would be €328 and the account would stop out after just 152 days.
No Man’s Land
Another possible risk of hedging is that your total P/L can change even if you are fully hedged and no fees apply. This can happen during moments of high volatility within the market and when the spread increases or decreases quickly. This can result in a stop-loss order if the account is near the 50% stop-out margin level.
Current EURUSD price: 1.20
EURUSD – 1 Lot – Long
Open Price: 1.15
The client decides to hedge the long EURUSD trade with an equivalent short trade.
EURUSD – 1 Lot – Short
Open Price: 1.20
Then the price of EURUSD moves to 1.17
EURUSD Long: -2010EUR
EURUSD Short: -3010EUR
*No swap charges are included
When should you consider hedging?
Hedging is a short-term strategy. You should avoid having a hedge open for more than a few days. There are two key circumstances during which you might employ hedging. These are:
No available funds
In order to free up margin, you can either deposit more money, close some of your positions, or hedge some positions. You might want to open a new trade and take advantage of an intra-day opportunity. However, if you cannot deposit more funds and do not want to close open trades, you can try hedging. By hedging the open trades, your free margin and margin level will increase, allowing you to open new trades.
If your margin level is low
You might need to increase your margin level if it is near the stop-out level (50%) and hedging is a way to achieve that. Also, if you do not want to deposit more money or incur a loss, hedging might be your only available option.
An example of this is if an economic announcement is due (NFPs/interest rates/earnings) and you do not want to risk it impacting your trades. To combat this, you can open a hedge. The NFPs (non-farm payrolls) are announced every first Friday of each month at 15:00 (GMT +2) and can have a big effect on the dollar and/or indices. You could open a hedge at 14:30 and close the hedge after the volatile period is over and the market is back to normal.
Potential Risks Associated with Requesting a Withdrawal While Hedging
If you decide to make a withdrawal while hedging, you would not be able to withdraw all the free margin (to calculate the amount you can withdraw, please refer here).
Even if you decide to withdraw the remaining free margin, this can result in two big risks:
1. Faster stop-out due to fees.
For example, the client below can withdraw €96,641 (€99,974 – €3,333) which is the true Free Margin after deducting the cost of hedging. This leaves the equity at €3,333, bearing in mind that the account will reach the stop-out level in 130 days.
2. A margin level much closer to the stop-out level when unhedged.
For example, the client below withdrew €96,641 (€99,974 – €3,333), which is the true Free Margin after taking out the effect of hedging. This leaves the equity at €3,333, so if the client decides to stop hedging his/her position, the margin level will be 100%.If the client did not make the withdrawal or open a hedging position, the margin level would be near 3,000% (as is the case below).
In other words, it is much easier for the client to reach the stop-out level when the margin level is 100% as opposed to 3,000%.