Forexbrokerpedia.com Money Management Techniques What is hedging and Cross Hedging

What is hedging and Cross Hedging

June 19, 2010 Daniel Jill 0 Comments

Hedging means we are opening two opposite positions, so even if prices rise or fall floating value remains the same.

Hedging or Locking the term is taken because when we use this technique we locked position so that the value gains and losses are always moving in tandem.

Logically, this hedging technique is not allowed because it means we play with ourselves. try to imagine at the same time you do a buy position of 1 lot in GBP/USD and 1 lot sell position in GBP/USD. this means that your profit in one position is your loss in another position.

Cross-hedging means that we are opening two opposite positions on different currency pairs but still allied. Cognate intention here is the trend of the movement of the currency pair tend to be the same, like: GBP/USD with EUR/USD; AUD/USD with NZD/USD.

Sample case

Mr.X predict the price of GBP/USD will go up so he opened Buy positions with the hope that prices will rise.

Oops, that the price down …….

Mr. X re-analyzes and conclusions: USD indeed strengthened but weakened again (Price GBP/USD is going down but will rise again)

He decided …….

  1. Holding Buy GBP/USD (not closed)
  2. Open a new position Sell EUR/USD (in order to profit when the EUR/USD down)

Now watch what happens

For example, he bought 1 lot GBP/USD current price of 1.9930 and 1.9927 today its price, so the loss of 3 points (1.9927 – 1.9930)

Then at that moment he opened position Sell 1 lot of EUR/USD current price of 1.5888.

Now note that the price of GBP/USD moves to 1.9925 and EUR/USD move to 1.5900

  1. Position Buy GBP/USD: 1.9925 – 1.9930 = -5 point (loss)
  2. Position Sell EUR/USD: 1.5900 – 1.5888 = 2 points (profit)
  3. TOTAL Income: -5 + 2 = -3 point

What if the price of GBP/USD moves to 1.9934 and EUR/USD move to 1.5881

  1. Position Buy GBP / USD: 1.9934 – 1.9930 = 4 points (profit)
  2. Position Sell EUR / USD: 1.5881 – 1.5888 = -7 point (loss)
  3. Income TOTAL: 4 + (-7) = -3point

In conclusion: because of the direction of the GBP/USD and EUR/USD tends to equal, then the total income will also likely be in the -3 point

We proceed to the story we go back now then the price of EUR/USD moves to 1.5880 then Mr. X immediately closed position Sell EUR/USD opened at a price of 1.5888 so he profit 8 points

And after a while

In accordance with the predictions of Mr. X price of GBP/USD go up to 1.9936, then he closed the Buy position opened at 1.9930 price so it profit 6 points.

Tips for you:

  1. Cross hedging can be used to analyze and generate profit as an example the case of the above
  2. The movement of the currency pair is allied not always unidirectional. Sometimes GBP/USD moving up, but  EUR/USD move down. This may happen if the currency which has strengthened GBP and EUR decreased.
  3. The movement of the currency pair that is allied not always identical. This means that if GPB/USD gained 5 points, does not mean that the EUR/USD is also definitely strengthened as much as 5 points.

Cross hedging weaknesses:

  1. The currency that is allied not always unidirectional.
  2. Even if the direction is not identical. Here’s an example, assuming today GBP/USD rose by 100 points, EUR/USD also rose, but only 50 points. It means that they both rose but not identical (100 points).