A common question I get about hedging is: Why not just use a stop loss to exit a losing trade?
That's a good question. In reality, both methods work. It just depends on your personality and which one you like more.
However, if you've been using stop losses, and it hasn't been working for you, then maybe it's time to try something new.
Hedging can make losses psychologically easier to handle and put you in control of when you take a loss. It can be a more consistently profitable way to trade, and it usually gives you more trading opportunities, compared with strategies that use stop losses.
Now that you understand the overall benefits, let's dive into the details.
The Biggest Psychological Benefit of Hedging
If you use a stop loss to exit losing trades, the market basically decides when you take a loss.
With hedging however, YOU decide when you take a loss.
In principle, taking a loss now and taking a loss later are basically the same thing.
From a psychological perspective however, it can be a huge benefit to be able to take your losses only after you have banked a profit.
This means you don't have to wonder how long your losing streak will be, before you get another win.
You have more control over the process.
Provides Opportunties to Take Smaller Losses
Would you rather take a $2,000 loss…or 3 losses of $800, $600 and $600?
Again, they are basically the same thing. But the difference is in the psychological impact.
I personally like the idea of taking smaller losses, instead of one big loss.
Even after I thoroughly backtest a strategy and know what to expect in terms of losses, it can still be tough to take several full losses in a row.
The great thing about hedging is that you can break up your losses into smaller pieces and roll them off at a time that's convenient for you.
That can make your losses easier to handle.
More Consistent Returns
I've heard of traders who claim that they are net profitable every day, using hedging.
Although I haven't verified that claim personally, I believe that it's certainly possible.
I do know however, that hedging can be profitable every month, and possibly even every week.
It just depends on how you implement hedging and how much time you have to trade.
Contrast this to other trading methods where it can be easy to have a down month and very easy to have a losing week.
Obviously, hedging is not a holy grail trading method that will guarantee profits.
You will have to put in the time and effort to get good at it, just like with any other trading method.
But in my personal experience, it can be a very consistent trading strategy, when you know what you're doing.
Scalable Across All Time Frames
Hedging is a method that can legitimately be used on all time frames.
I've bought trading education courses where the instructor says that their strategy works on all time frames.
But when you actually backtest it, you realize that most of the time, that's not true.
There are a few stop loss strategies that do work across several timeframes, but in my experience, they are very rare.
In reality, most trading strategies work best on one or two timeframes.
With hedging however, it can truly be used on all timeframes because it's a framework and not a strict set of trading rules.
No Stop Loss to Trigger
Many traders complain about their stop loss getting triggered prematurely.
This is a legitimate concern when you use stop losses.
That's why many professional traders don't use stop losses.
A legitimate broker isn't going to trigger your stops intentionally. To find out who does, read this.
But even if you put your stop loss in the exact right spot, you can still get stopped out unnecessarily.
The spread can differ greatly between brokers.
So if you follow a trading strategy that says to use a 30 pip stop loss, you'll get stopped out a lot more at a broker that has wide spreads.
But if you don't use a stop loss and hedge instead, you cannot get stopped out, no matter how wide the spread at your broker is.
After the New York session closes, the Forex market goes through a period called the interbank market where the majority of foreign exchange trading transfers from New York to smaller markets like Sydney.
Spreads get really wide during this period and can take out your stop loss. Here's an example of how dramatic the difference can be.
So if you're using a stop loss, you could easily get stopped out if your stop is too close, or you're trading a pair where the spread gets really wide.
However, if you don't have a stop loss and you're using a hedge instead, then you simply cannot get stopped out.
The final way that you can get stopped out before you expected, is high market volatility.
If you've been trading for any amount of time, you've probably seen something like this.
You went long and thought your stop loss (red line) was safe, but a temporary price spike takes it out. Then it goes in the direction that you expected.
The reality is that these spikes do happen often and the only way to manage your risk without getting stopped out is to use a hedge.
When you use a stop loss, you have a fixed amount of risk on a trade.
Don't get me wrong, that's generally a good thing.
But hedging can provide more fine-tuning, in terms of how much risk you want to take on a trade.
For example, let's say that you want to go long here. If you're wrong about the trade, you're going to consider hedging at the red line.
Now if price gets down to the level where you think you're wrong about the trade, you have the following options:
- 0% hedge (e.g. 1 lot long, 0 lot short): You are very sure that price will move up and you can sit around and watch the chart.
- 25% hedge (e.g. 1 lot long, 0.25 lot short): You are pretty sure that price will move up, but you want to have a little downside protection.
- 50% hedge (e.g. 1 lot long, 0.50 lot short): You think price will probably go up eventually, but you aren't sure.
- 100% hedge (e.g. 1 lot long, 1 lot short): You don't know where price is going to go, so you want to “pause” the loss until the price action becomes clearer.
- Or anything in between!
Having a partial hedge gives the market room to move, while limiting your loss. If you are partially hedged and price ultimately moves in the direction you expected, you still make money.
When you use a stop loss, there can only be 2 results…gain or profit.
With hedging, there are many shades of gray.
I would say that hedging is probably the most flexible trading method around.
It's also one of the purest forms of price action trading, if you don't use indicators.
However, the great news is that you can still hedge, even if you use an indicator based entry strategy.
Some traders have told me that they trade a standard trading strategy with indicators, but they use hedging to exit the trade, instead of a stop loss.
Hedging also allows you to make money in both directions at the same time. You don't only have to be long or short, then wait for a setup in the opposite direction.
You can make money when the price goes up and down.
So if you don't like being confined to a specific set of rules all the time, Forex hedging might be the alternative that you've been looking for.
Earn Positive Interest
There can be times when you can actually make positive interest every week by holding a hedge.
This will depend on the interest rate environment between the central banks, but it's possible to hold a partial hedge and earn interest.
For example, the swap on the USDJPY is currently 11.55 on the long side and -19.38 on the short side.
So if you held 1.0 standard lot long and 0.25 short, you would be partially protected if price drops.
But the great news is that you would be earning net positive interest on the hedge.
In fact, you could be 50% hedged and still be making a small amount on the swap interest.
To me, this is the closest thing that you'll get to passive income in Forex trading.
Now you should obviously do this in an area on the chart that looks like a good place to go long. If you get a good entry and price stays above your entry price for a long time, you simply accumulate profits.
Just be sure to track the swap rates of the currencies you trade because they can change suddenly.
This might sound like a bad thing, but it's actually a very good thing.
In a world where AI and algo trading is becoming increasingly popular, it's becoming easier to figure out the mechanical trading systems that successful traders are using.
If enough traders start making money with a particular trading strategy, someone somewhere in the world will figure out how to reverse engineer it and turn it into an algorithm.
If enough money starts getting traded with these algorithms, the systems will start to lose their profitability.
I know that those are a couple of big “ifs,” but it can happen, especially with the power of computers nowadays.
However, since hedging does not rely on a mechanical set of rules, it cannot be reverse engineered and is more likely to work in the future.
Hedging will also allow you to adapt to changing market conditions, so you won't get stuck with a trading strategy that stops working.
I feel that hedging is also more fun than other trading strategies because it's like figuring out a puzzle.
You have to figure out how to get out of a hedge and get to flat as soon as possible. There are many ways to do this, and working through the options is a fun exercise.
Contrast that to following a set strategy every day.
You follow the same rules and there is no variety.
Nothing wrong with that obviously. It's great when you can rely on a trading system to make money.
But some people might get a little bored.
So if you have trouble motivating yourself to trade, even if you're consistently profitable, then hedging might be a great way to keep your brain engaged in the process.
Hedging can be a great way to trade Forex.
It's not for everyone, but if you resonated with the reasons above, then it could be a great method for you.
They key is to give it a try in a demo account and see how you like it.
Also be sure to download my free guide to Forex hedging here.