At this point in our trading education, we should be aware of the fact that FX spreads are variable and can widen to levels several times larger than their typical spreads. These spread increases are most often seen during news releases and can affect our positions rapidly. But, what is the best way to weather the storm during times of widening spreads?
How to Truly Protect Ourselves Against Widening Spreads
The only way to protect ourselves during times of widening spreads is to restrict the amount of leverage used in our account (which in my opinion, should be less than 10x leverage). Spreads can only hurt us when a trade is being opened or closed. If we aren’t opening or closing a trade during a news events, we won’t be affected. Prices will eventually go back to normal and at some point we will close on our own terms.
The only time the market can force our hand to liquidate our positions is with a margin call. If we reduce our leverage, we reduce our chances of liquidation.
The “Hedging” Myth
Helping traders around the world means that I have seen many different methods to trade this market, both good and bad. One of the most damaging methods I’ve come across is the idea of ‘hedging’ a Forex trade by opening an opposing trade in the same currency pair and holding both long and short positions simultaneously. This not only incurs greater trade cost (by paying additional spread) but does not protect your position against additional losses.
Hedgers attempt to lock-in their profit or loss on a trade by opening an opposing trade, but if the spread widens, this negatively affects both sides of the trade. If the trader is over leveraged on these trades, a wider spread could incur a margin call and liquidate both positions. Worst of all, you would most likely be filled at the widened spread prices, adding insult to injury.
So now we know, hedging is not the proper way to secure a profit or a loss. Only the closing of a position can do that. Hedging also can be dangerous around widening spreads and can cause margin calls, so we need to limit the amount of leverage we are using to 10x or less.
Next: What is Leverage? (29 of 48)
Previous: Beware of the Spread
---Written by Rob Pasche