Advantages of Forex Hedging vs Stop Loss

<p>A common question I get about hedging is: <strong>Why not just use a stop loss to exit a losing trade? </strong></p>
<p>That's a good question. In reality, both methods work. It just depends on your personality and which one <em>you</em> like more.</p>
<p>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.</p>
<p><strong>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. </strong></p>
<p>Now that you understand the overall benefits, let's dive into the details.</p>
<h2>The Biggest Psychological Benefit of Hedging</h2>
<p>If you use a stop loss to exit losing trades, <em>the market</em> basically decides when you take a loss.</p>
<p><strong>With hedging however, <em>YOU</em> decide when you take a loss.</strong></p>
<p>In principle, taking a loss now and taking a loss later are basically the same thing.</p>
<p><strong>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.</strong></p>
<p>This means you don't have to wonder how long your losing streak will be, before you get another win.</p>
<p><em>You have more control over the process.</em></p>
<h2>Provides Opportunties to Take Smaller Losses</h2>
<p>Would you rather take a $2,000 loss…or 3 losses of $800, $600 and $600?</p>
<p>Again, they are basically the same thing. But the difference is in the psychological impact.</p>
<p>I personally like the idea of taking smaller losses, instead of one big loss.</p>
<p>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.</p>
<p><strong>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. </strong></p>
<p>That can make your losses easier to handle.</p>
<h2>More Consistent Returns</h2>
<p>I've heard of traders who claim that they are net profitable every day, using hedging.</p>
<p>Although I haven't verified that claim personally, I believe that it's certainly possible.</p>
<p><strong>I do know however, that hedging can be profitable every month, and possibly even every week.</strong></p>
<p>It just depends on how you implement hedging and how much time you have to trade.</p>
<p>Contrast this to other trading methods where it can be easy to have a down month and very easy to have a losing week.</p>
<p>Obviously, hedging is not a holy grail trading method that will guarantee profits.</p>
<p>You will have to put in the time and effort to get good at it, just like with any other trading method.</p>
<p><em>But in my personal experience, it can be a very consistent trading strategy, when you know what you're doing.</em></p>
<h2>Scalable Across All Time Frames</h2>
<p>Hedging is a method that can legitimately be used on all time frames.</p>
<p>I've bought trading education courses where the instructor says that their strategy works on all time frames.</p>
<p>But when you actually backtest it, you realize that most of the time, that's not true.</p>
<p>There are a few stop loss strategies that do work across several timeframes, but in my experience, they are very rare.</p>
<p><em>In reality, most trading strategies work best on <strong>one or two</strong> timeframes. </em></p>
<p>With hedging however, it can truly be used on all timeframes because it's a framework and not a strict set of trading rules.</p>
<h2>No Stop Loss to Trigger</h2>
<p>Many traders complain about their stop loss getting triggered prematurely.</p>
<p>This is a legitimate concern when you use stop losses.</p>
<p><em>That's why many professional traders don't use stop losses.</em></p>
<p>A legitimate broker isn't going to trigger your stops intentionally. To find out who does, <a href="https://www.tradingheroes.com/do-brokers-hunt-your-stop-losses/" target="_blank" rel="noopener">read this</a>.</p>
<p>But even if you put your stop loss in the exact right spot, you can still get stopped out unnecessarily.</p>
<p>Here's how…</p>
<h3>Variable Spreads</h3>
<p>The spread can differ greatly between brokers.</p>
<p>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.</p>
<p>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.</p>
<h3>Interbank Market</h3>
<p>After the New York session closes, the Forex market goes through a period called the <a href="https://www.babypips.com/tools/forex-market-hours" target="_blank" rel="noopener">interbank market</a> where the majority of foreign exchange trading transfers from New York to smaller markets like Sydney.</p>
<p>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.</p>
<p><img decoding="async" class="size-full wp-image-1023033 aligncenter" src="https://www.tradingheroes.com/wp-content/uploads/interbank-spreads.jpg" alt="Interbank market spreads" width="693" height="507" /></p>
<p>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.</p>
<p>However, if you don't have a stop loss and you're using a hedge instead, then you simply cannot get stopped out.</p>
<h3>Market Volatility</h3>
<p>The final way that you can get stopped out before you expected, is high market volatility.</p>
<p>If you've been trading for any amount of time, you've probably seen something like this.</p>
<p><img decoding="async" loading="lazy" class="alignnone size-full wp-image-1023037" src="https://www.tradingheroes.com/wp-content/uploads/NZDCHF_2023-04-27_23-02-15.png" alt="Long spike" width="1801" height="780" srcset="https://www.tradingheroes.com/wp-content/uploads/NZDCHF_2023-04-27_23-02-15.png 1801w, https://www.tradingheroes.com/wp-content/uploads/NZDCHF_2023-04-27_23-02-15-768×333.png 768w, https://www.tradingheroes.com/wp-content/uploads/NZDCHF_2023-04-27_23-02-15-1536×665.png 1536w" sizes="(max-width: 1801px) 100vw, 1801px" /></p>
<p>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.</p>
<p><strong>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. </strong></p>
<h2>Adjustable Risk</h2>
<p>When you use a stop loss, you have a fixed amount of risk on a trade.</p>
<p>Don't get me wrong, that's generally a good thing.</p>
<p><strong>But hedging can provide more fine-tuning, in terms of how much risk you want to take on a trade. </strong></p>
<p>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.</p>
<p><img decoding="async" loading="lazy" class="alignnone size-full wp-image-1023034" src="https://www.tradingheroes.com/wp-content/uploads/USDCAD_2023-04-27_22-40-16.png" alt="Long example" width="1801" height="786" srcset="https://www.tradingheroes.com/wp-content/uploads/USDCAD_2023-04-27_22-40-16.png 1801w, https://www.tradingheroes.com/wp-content/uploads/USDCAD_2023-04-27_22-40-16-768×335.png 768w, https://www.tradingheroes.com/wp-content/uploads/USDCAD_2023-04-27_22-40-16-1536×670.png 1536w" sizes="(max-width: 1801px) 100vw, 1801px" /></p>
<p>Now if price gets down to the level where you think you're wrong about the trade, you have the following options:</p>
<ul>
<li>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.</li>
<li>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.</li>
<li>50% hedge (e.g. 1 lot long, 0.50 lot short): You think price will probably go up eventually, but you aren't sure.</li>
<li>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.</li>
<li>Or anything in between!</li>
</ul>
<p><strong>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.</strong></p>
<p>When you use a stop loss, there can only be 2 results…gain or profit.</p>
<p><em>With hedging, there are many shades of gray.</em></p>
<h2>More Flexibility</h2>
<p>I would say that hedging is probably the most flexible trading method around.</p>
<p>It's also one of the purest forms of <strong>price action trading</strong>, if you don't use indicators.</p>
<p>However, the great news is that you can still hedge, even if you use an indicator based entry strategy.</p>
<p>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.</p>
<p><strong>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.</strong></p>
<p>You can make money when the price goes up <em>and</em> down.</p>
<p>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.</p>
<h2>Earn Positive Interest</h2>
<p>There can be times when you can actually make positive interest every week by holding a hedge.</p>
<p>This will depend on the interest rate environment between the central banks, but it's possible to hold a partial hedge and earn interest.</p>
<p>For example, the swap on the USDJPY is currently 11.55 on the long side and -19.38 on the short side.</p>
<p><img decoding="async" loading="lazy" class="size-full wp-image-1023028 aligncenter" src="https://www.tradingheroes.com/wp-content/uploads/Screen-Shot-2023-04-27-at-5.17.08-PM.png" alt="Swap on USDJPY" width="433" height="41" /></p>
<p>So if you held 1.0 standard lot long and 0.25 short, you would be partially protected if price drops.</p>
<p><strong>But the great news is that you would be earning net positive interest on the hedge. </strong></p>
<p>In fact, you could be 50% hedged and still be making a small amount on the swap interest.</p>
<p>To me, this is the closest thing that you'll get to passive income in Forex trading.</p>
<p>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.</p>
<p><em>Just be sure to track the swap rates of the currencies you trade because they can change suddenly. </em></p>
<h2>Be Unpredictable</h2>
<p>This might sound like a bad thing, but it's actually a very good thing.</p>
<p>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.</p>
<p>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.</p>
<p>If enough money starts getting traded with these algorithms, the systems will start to lose their profitability.</p>
<p>I know that those are a couple of big “ifs,” but it can happen, especially with the power of computers nowadays.</p>
<p><strong>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. </strong></p>
<p><em>Hedging will also allow you to adapt to changing market conditions, so you won't get stuck with a trading strategy that stops working.</em></p>
<h2>More Fun</h2>
<p><strong>I feel that hedging is also more fun than other trading strategies because it's like figuring out a puzzle.</strong></p>
<p>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.</p>
<p>Contrast that to following a set strategy every day.</p>
<p>You follow the same rules and there is no variety.</p>
<p>Nothing wrong with that obviously. It's great when you can rely on a trading system to make money.</p>
<p>But some people might get a little bored.</p>
<p>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.</p>
<h2>Final Thoughts</h2>
<p>Hedging can be a great way to trade Forex.</p>
<p>It's not for everyone, but if you resonated with the reasons above, then it could be a great method for you.</p>
<p><strong>They key is to give it a try in a demo account and see how you like it.</strong></p>
<p>Also be sure to download my <span>free guide to Forex hedging here</span>.</p>
<p>The post <a rel="nofollow" href="https://www.tradingheroes.com/hedging-vs-stop-loss/">Advantages of Forex Hedging vs Stop Loss</a> appeared first on <a rel="nofollow" href="https://www.tradingheroes.com">Trading Heroes</a>.</p>