Best Forex Broker for Hedging
One of the top Brokers for hedging reviewed by BrokerNotes is CMC Markets. However, it should be noted that one of the main disadvantages of CMC Markets is they do not offer the MT4 trading platform. For traders that require a broker with the Meta Trader platform, check our comparison of the best brokers that offer the MT4 platform. For traders that do not require the MT4 platform, see why traders prefer CMC Markets below.
Advantages of CMC Markets
- Regulated by the Financial Conduct Authority: CMC Markets UK plc (173730) and CMC Spreadbet plc (170627) and the Gambling Commission, for their Binary option products, reference number 42013
- Ability to hedge most trades with over 10,000 instruments
- Comprehensive educational material
- Wide range of risk management features including their Guaranteed Stop Loss Orders (GLSO)
- Dedicated support whenever the markets are open
What is hedging in forex trading?
In terms of forex trading, hedging is a strategy used by traders to protect a trading account from incurring large losses when something unexpected happens, by trading in both directions of a trade. A hedge can be viewed as a form of partial insurance against unexpected events and price movements that could occur and lead to losses in the forex market.
There are different forms of hedging. Most of these methods can be classified unofficially into simple and complex hedging methods.
Also known as direct hedging, simple hedging in forex implies opening two opposing positions on the same currency pair. In other words, you open a trade position in one direction and open another trade in a direction which is opposite to the initial trade, while the initial trade is still active. If a trader has open a long trade of 0.5 lots on the EURUSD, the hedge trade would be to open a short trade position of 0.5 lots on the EURUSD, with both trades running at the same time on the same account. What most traders do is to open a position, and when it starts to move negatively, they open another position in the other direction. They may then allow the currency pair to achieve a significant movement in one position, take profit and then adjust the stop for the other position to allow it to recover to some extent if the analysis for the currency permits this.
Complex hedging techniques involve a number of methods which are not restricted to the spot forex market alone. A true complex hedge will involve trading on a currency pair in the spot forex market and set up a contrarian trade as a hedge in the forex options market. How does this work?
Let us assume that Trader John has a long trade setup in the spot forex market on the EURGBP to try to profit from the depreciation of the British Pound post-Brexit. In order to hedge against suffering a loss on this trade from a pound appreciation, John decides to purchase an option with a strike price that is lower than the price at which the EURGBP spot trade was made. This action, therefore, limits the downside risk of the spot trade. If the EURGBP goes up as expected, the trade gains from the spot forex trade and will only lose the premium paid on the option trade. If the EURGBP falls, then the spot trade will be closed off at the stop loss and the options trade then has potential to be profitable, depending on the number of contracts purchased and the scale of the move. This form of hedging is practised by institutional traders and that is partly responsible for why they make a lot of money even when markets are falling behind expectations.
Factors to Consider When Choosing a Broker for Hedging
Regulation of the broker must always be considered when choosing a broker for hedging. Hedging is inherently risky and some brokers do not always provide conditions that favour hedging. As with all types of trading, going with a regulated a regulated broker would be a prudent decision. Regulators like the Financial Conduct Authority have rules in place concerning hedging instruments, for example, their policy regarding Interest Rate Hedging Products.
By choosing a regulated broker, you are using a broker that is mandated by law to follow those rules, which ultimately protects you, the trader.
2. The Hedging Style Allowed by the Broker
There are several methods of hedging. If you cannot use the simple hedging method or you find it too risky, you can use other methods. Your broker will determine what style of hedging you can perform, following the dictates of the regulators.
3. Size of the Account Capital
Hedging is better suited for traders with bigger accounts because it requires the use of more margin for opening new, opposing positions. Effectively a trader who hedges their trades would require twice the capital of a trader who does not.
Advantages of Hedging
The following are advantages of the use of hedging:
a) When used correctly, hedging can protect traders against losses.
b) Hedging provides the opportunity for traders to expand their trading skills set.
c) Hedging is an indispensable tool for capital preservation when markets are in turmoil.
Disadvantages of Hedging
As with all trading strategies, hedging has the possibility to lead to losses and should not be considered a safe method of trading. Hedging has its costs and the potential benefits must be taken into account before justifying the cost of a hedge. It is important to remember that the goal of a hedge is not to make money but to protect you from losses.