If the EURUSD and GBPUSD have such a high correlation and I enter into a LONG position on the EURUSD, why not also go SHORT the GBPUSD in case the EURUSD LONG position hits our stop loss so that when we exit the GBPUSD we come out with a profit leaving us with no loss at all?”
This is a VERY good question.

Let’s answer this question by understanding the fundamentals behind it.
When you place a trade you have two plausible outcomes: 1) you lose money, 2) you make money (and okay, there’s a third: you can breakeven).
Now the greatest level of risk on our capital occurs when we implement the trade. Here’s why: when we place the trade the worst that can happen (excluding slippage) is that our stop loss gets hit and we lose. At any other point during our trade we can increase our stop and thereby decrease the loss (i.e. risk) on our capital. Read this again if it didn’t make sense - it’s very important.

So, if we know that when we place the trade we are at our greatest risk level, are there ways we can reduce, or minimise this risk? Could there perhaps, be a way where we can minimise our risk on capital to zero?

This is where my thoughts led me to the EUR/USD and GBP/USD trades. Instead of losing out on our EUR/USD trade when our stop loss gets hit, why not implement a trade on a highly correlated currency that would make money if the EURUSD lost?

By way of an example: If the EUR/USD was trading at 1.2307 on the bid price at exactly 1500 EST, if we had entered into a SHORT trade at that time, placed a 15 pip stop loss and entered the GBP/USD LONG at the same time at 1.8181 (the bid was 1.8178 + 3 pip spread) with also a 15 pip stop, what would have happened?

In this example the EUR/USD would have had us stopped out at our 15 pip stop loss. But what happened to outr GBPUSD trade? By the time the EUR/USD trade had hit our stop the GBP/USD was only trading at 1.8179 (on the bid) losing us a further 2 pips. In summary then, these trades lost us 17 pips.
So much for hedging.

But wait...
What if we had instead entered into a SHORT position on the USD/CHF? The EUR/USD & USD/CHF correlations have a very high NEGATIVE correlation meaning that if we enter LONG in one of the currencies we enter LONG in the other currency too. So, what would have happened?
Our USD/CHF short position would have been in at 1.2518 (the bid price), our exit price would then have been at 1.2504 (the bid price was 1.2501 + 3 pip spread), making us 14 pips! Overall we would have only lost 1 pip! What would you prefer: losing 15 pips, or losing 1 pip?

HOWEVER...
What if our EUR/USD trade had been correct, what would we have done if our USD/CHF trade exited at its stop loss?
Unfortunately this is where the trading process begins to become a little messy. If our original trade makes money and our hedged position follows it and we place a similar stop to our hedged trade and it does get stopped out, what will happen if our original trade then begins to reverse? We would have incurred a loss on our hedged position and if our stop loss hasn’t moved to breakeven yet we may make a further loss on our original position - we would have doubled our risk!!

What can we do? Is hedging worth it?

Well, as our first example showed the hedging did quite well (provided we picked the right currency to hedge with!), and I guess this already brings out an important point: just because we hedge with a highly correlated currency does not guarantee that our method will work.

Let’s look at some of the scenarios that can happen with our hedging strategy and see what possible solutions we can offer for the problematic ones…

1) The original trade loses and our hedge trade loses:

Have AT LEAST 15 pip stops on both your original and hedged trade. If you have less than 15 pip stops you will probably be just catching normal market fluctuations
Visually check (or manually calculate) to make sure that the currencies are indeed currently observing high correlations. Just because the currencies observed high correlation last week might not necessarily mean that they are doing it again. Also be aware that the correlation table only corresponded to DAILY closing prices, it may be an entirely different story on 1 minute, or 60 minute charts
As no guarantees can be made to highly correlated trades, be sure that if both trades were to hit their stop losses that the risk on capital is minimal
Watch out for any country specific economic reports.

2) Our hedged trade loses:

Make sure that you do not lose any more capital! Don’t forget our number one rule: protect capital at all costs. At the least change your original trade stop loss to breakeven
Reduce your risk before you place your trade so that if both trades do lose you only still lose the amount of risk you are willing to take each trade
Have AT LEAST 15-20 pip stops on both your original and hedged trade. If you have less than 15 pip stops you will probably be just catching normal market fluctuations

3) Our original trades makes money and our hedged trade makes money:

This is ultimately the best situation to be in! I would recommend that once your original trade hits a certain price that you exit your hedged trade and move your stop loss on your original trade to breakeven
Hopefully this article has been beneficial to your understanding of hedged trades. Of course, before implementing any new strategy into your trading method be sure to test it out on a few demo accounts.