Hedging

I think what’s discussed called Hedging, at least that I have learnt.
I used Hedging to benefit from market swings, assuming I can identify a clear reversal point for my trades.

I also used Hedging to stoploss until I see market reaction and give myself the room to think about solving my loss.

That definiation is fine, but somewhat general. It falls short.

The fact of the matter is that nowhere but in forex does the term “hedging” even come close to suggesting taking an opposing position in the same instrument. No stock trader would ever short Google to hedge a long position in the stock. No futures trader would buy February Gold to hedge a short position in February Gold.

Maybe this is just my university finance education coming in to play here, but I look at hedging in terms of the intent. A hedge is meant to isolate a certain risk involved in a position (or a transaction to be made at a future time) and either reduce or eliminate it.

All I can say here is Yikes! Seems to me like you need to trade smaller.

Avoiding a margin call should never be the basis for any kind trading. The fact that you are even putting yourself at risk of one means you’re trading too big. I have never had a margin call in all the years I’ve traded forex for the simple reason that I don’t put my portfolio in that kind of risk. It takes a lot to come back from losing that percentage of your portfolio, both financially and psychologically.

Somewhere folks seem to have forgotten that spot forex trading is like futures. Your account is marked-to-market. That means it’s current value takes in to account the current open gains or losses of the positions you have on. To say that taking profits from these so called hedges boosts your balance is incorrect. Sure, it increases the realized p/l, but since you still have an open loss in the original position, there is no change in your total account value.

And when the market goes into a runaway trend you either miss out because you are all tied up in a net neutral position or you get slaughtered by being on the wrong side. Oh, but then you just put on another hedge, right? And lock in yet more losses.

Actually, I should think that brokers love this stuff. It creates extra transaction volume and they are happily grabbing the spreads and/or commissions from you.

Never say never…no disrepect though…but there are all kinds of “hedges” out there that involve just that…taking an opposite position from an outright futures postion, e.g., long Feb Gold at 620, and long a Feb 615 Put Option…it’s two opposing positions…not exactly as you stated…but this is used quite often in lieu of a stop loss in order to protect the long position…if Gold takes off to the upside…you just let the option expire worthless.

As far as the example of two futures contract though…true…you can never even execute long one Feb Gold and short one Feb Gold without offsetting…unless you crazily wanted to use two accounts…

But as far as hedging futures contracts…it’s not a crazy thing to be long Feb Gold and short April…in case you wanted to hold on to your position overnight but you expected some large move against you and didn’t wanted to use an option put or a stop loss…there is the issue, however, of which leg to drop and when…

Another “hedge” is spread trading…such as buying one contract and selling another in related markets…such as Britsh Pound and Canadian Dollar…the spead value between the two will either increase or decrease…and you can profit from that.

As you say, that isn’t a directly opposite position, and it’s not a hedge. You said it yourself. It’s a stop.

Hmmm. It’s not crazy to use seperate accounts (or sub-accounts) to take opposing long and short positions in forex, but it is in gold?

That’s called a calendar spread, not a hedge. You’re exposure is to changes in the price difference between the two contracts.

Spread trading is NOT hedging. It’s spread trading. It’s attempting to profit from changes in the price difference between two things. Your upside and downside are both unlimited.

As for “spreading” the Pound against the $C, you do realize that’s GBP/CAD, a cross rate, right? You can trade that outright - not easily via futures, but certainly in spot.

Thanks for the point-by-point analysis…my goal wasn’t to get into a huge debate…

Spread trading is a “form” of hedging, in that you are indeed deflecting some of the risk of an outright long or short position by taking an opposing position…this is all just semantics…but I do think that this type of trade does fit under the general heading of “hedging”…how that “hedge” is executed is variable…imho…

That word “some” is the point I’m making in differentiating what I consider hedging vs an offset. The hedge leaves some risk, which allows for profit or loss on the trade. The offset eliminates all risk, meaning no gain or loss can be made while the two positions are both one.

Point made my friend…I think you were making that point to someone else that maybe was not understanding what hedging is…and not to beat a dead horse…the other examples I gave are examples of hedges…although one would question the motives of the person doing a long Feb Gold, short April…the two contracts are not equal, and so do have a spread difference…and thus one is actually “hedging” the risk of the outright long…either to wait out an adverse move, or to profit from an increasing spread…and the other example of long Feb Gold and Long Feb Put is, imo, a “hedge” also, since you have two active opposing positions, both going up or down in value…an offset, or SL is not active in the market(at least from a futures viewpoint) until it’s executed…and then, the position is gone altogether…

“Hedging” in forex, the way I’m reading about in this thread…where one is trying to buy and sell the same instrument in two accounts is an offset also…true dat…although the two positions are still active…

One other form of supposed ‘hedging’ I see around at the moment is the use of correlated pairs, where the aim is to make money off the daily interest. FreedomRocks and ForexForSmarties are two such programs that I’ve come across that go down this route.

If you’re going to use this sort of system know what you’re getting into!

Using multiple forex pairs for correlation purposes does not result in a perfect hedge, and you would be well advised to learn what factors that will impact on the resulting cross rate(s).

Other than that I just gotta say that there’s some good info in this thread about hedging in forex land. When you’re ‘hedging’ on the same forex pair all you’re really doing in effect is just reducing your exposure/open lot size.

I will occasionaly use it but find that it just makes things more complex than I would like. If a position is going against me and I think it’s going to continue going against me, I’d rather just get out, instead of hedging it and then having to deal with when to close the hedge as well.

So true. It goes back to the old statment “there’s no free lunch”. To make money in the markets (and elsewhere) you must take some risk.

Correlated pairs do not move in tandem 100% of the time. All it takes is one terrorist incident or something like that for scared money looking for a safe haven to flow in to the Swissy (EUR and CHF most often used in these kinds of trades) and completely blow apart the correlation - and lots of people’s positions!

Other than that I just gotta say that there’s some good info in this thread about hedging in forex land. When you’re ‘hedging’ on the same forex pair all you’re really doing in effect is just reducing your exposure/open lot size.

I will occasionaly use it but find that it just makes things more complex than I would like. If a position is going against me and I think it’s going to continue going against me, I’d rather just get out, instead of hedging it and then having to deal with when to close the hedge as well.

Amen, brother!

Forex traders assume risk to turn a profit. To eliminate risk is to eliminate profit. I see no place for hedging in our business. I cant even think of a situation where hedging would increase my profits or cut my losses.

I’m not familiar with that type of hedge…but when you mentioned ‘correlated pairs’, that brings me back to spread trading…which when done correctly, you buy one instrument and sell another because they have a ‘correlation factor’ that is very positive…meaning that on most days when one is moving up, the other one is too, and vice versa for down moves…but that doesn’t mean that they always move together 100 percent of the time…in fact, when it appears that they aren’t moving together, someone might buy the spread or sell the spread between the two…and they would do so with the knowledge that eventually the spread will come back inline with the norm for the two instruments…

Anyway…that’s my two cents…so, to Rhodytrader…you may be correct in saying that spread trading is not a ‘hedge’ at all if the correlation goes haywire for some reason or another…and it just becomes two open positions with no stop loss on either…which would be nightmarish if it happened…

Yeah, you pretty much have it right there. The one question that people who are considering trading correlated pairs looking to ‘hedge’ themselves need to ask is ‘why don’t I just trade the resulting cross-rate instead?’

If you attempt to ‘hedge’ yourself by trading EUR-USD and USD-CHF, you have hedged against any moves in the US dollar, but what the euro and Swiss franc get up to is going to affect you. Why not just trade EUR-CHF instead and save yourself the spread?

If you visit my homepage you’ll find a pretty big article I wrote about correlations recently which hopefully highlights the pros and cons of attempting this kind of hedge.

Just wondering…since I don’t know this one for sure at all…but aren’t US-based forex clients limited to trading only those pairs that involve the USD? Yeah…a newbie question…

Absolutely not!

You are only limited in the pairs you can trade by what your broker offers. That said, for a new trader it is easier to deal with the USD pairs only for a while as the crosses can be confusing in their p/l calculations and such.

I read the article on your website, Colin…nice work…

My comments(only for the sake of keeping a good thread going)…which are based on my knowledge obtained on spreads in general…from none other than Joe Ross(et al) on his website(which you mention elsewhere in another article written on your site…and he is a great source of information on spreads and trading…Trading Educators Inc. - Joe Ross - Day Trading and Online Trading) …are these…and feel free to fire away if you think I’m off base:

  1. When you say “why not just trade EUR-CHF naked” instead of EUR-USD and USD-CHF…we’re forgetting that there are four separate actions that can be performed on the two pairs,e.g., a.)buy EUR-USD and buy USD-CHF…or b.) sell EUR-USD and sell USD-CHF…or c.) buy EUR-USD and sell USD-CHF…or d.) sell EUR-USD and buy USD-CHF.

The first two choices a and b would be the only actions allowed on EUR-CHF since we are taking USD out of the equation by trading EUR-CHF. Choice a and b make sense, of course, if we are talking about positively correlated currency pairs, i.e., if EUR-USD goes up, then most likely USD-CHF will too, and likewise, if EUR-USD goes down then USD-CHF will too…but since this correlation is not fixed, then of course the pairs can go in different directions…since A converts to B and B converts to C implies that A converts to C, which they do of course…but not perfectly equal…and therein lies the correlation of less than 100 percent…and a reason why I think ForexForSmarties keeps separate pairs trades…because of choice c and d above, buy one and sell the other, or sell one and buy the other. They are, I believe, trying to ‘balance’ the losses and gains between the two pairs under a predefined limit, and I believe they are doing their small ‘buys’ and ‘sells’ during the day to ‘skew’, as you said, the balance up or down based on how out of line the pairs are in relation to their correlation factor. From what I read on their site, it sounds as if they are just trying the keeps things ‘delta neutral’(to use an options term) as far as the impact of the spreads…meaning that they are trying the keep losses or gains between positive amount A and negative amount B, and then capturing the interest ‘carry’ over time.

  1. …and this is just about spread trading in general…another reason one would trade a spread instead of naked position…and we’re talking about outright futures, stocks(if one had the margin) and forex depending on what you’re trying to achieve…is so that you can avoid having a stop loss actually in the market to be hit…since we’re talking about two highly correlated positions…you could just monitor them daily without execessive fear that the spread will go awry overnight…you can use ‘mental’ stop losses instead of actual ones placed in the market…of course when it hits your mental stop loss because the spread is going against you…you need to get out. Again…from the Joe Ross website…good stuff there.

Yeah, Joe Ross has some written some good stuff. I’ve read most of his stuff on price action, but surprisingly have not read his spread trading material. Must remedy that at some stage.

Very good point. I can only hope that FreedomRocks and ForexForSmarties are this smart when it comes to managing the main open trade. The fact that they are both black box systems means you have to put some faith in their system to keeping things ‘delta neutral’. From demo trading the FR system I’m not 100% if they’re doing it that way, but I’m going to keep trialing to confirm it one way or another. Buying unbalanced lot sizes in the two currencies is the only way I can see to keep things in check. I wonder how soon the unbalancing begins to have a detremental effect on the interest payments if a retracement gets underway?

If you’re worried about stop running, or otherwise giving your broker more information about your position strategy than you’d like then mental stops are the way to go. Of course, you have to make sure that you have the discipline to keep to them.

While it’s true that there are four possible options, let’s think about what these options really equate to:

a) Buy EUR/USD and buy USD/CHF - Equals long EUR/CHF
b) Sell EUR/USD and sell USD/CHF - Equals short EUR/CHF
c) Buy EUR/USD and sell USD/CHF - Equals double USD short with longs in both EUR and CHF
d) Sell EUR/USD and buy USD/CHF - Equals double USD long with shorts in both EUR and CHF

I can understand the basic idea of “hedging” in terms of a) and b) since EUR/USD and USD/CHF are generally negatively correlated (meaning EUR and CHF trade broadly in the same direction)

Where is the hedge in c) and d), though? Those are outright positions which basically matched because they would be expected to profit or lose under the same circumstances (EUR/USD rises as USD/CHF falls and vice versa).

First, I thought that if two pairs trade broadly in the same direction that they would be positively correlated…maybe I’m wrong…

Second, I mentioned c and d and possible actions on the pairs…and wasn’t implying that all four actions were hedging moves…c and d might be a ‘counterbalancing’ type of move…although I haven’t analyzed what its true impact would be if a or b were undertaken…I was just stating the possible options though…

Note that I said EUR and CHF generally trade in the same direction, thus are positively correlated. I didn’t say the pairs.

Since EUR/USD and USD/CHF are essentially the reverse of each other (USD is the base in one, but not in the other), the pairs are generally negatively correlated.

Were c or d used to counterbalance an a or b position, the net result (assuming equal position sizes of course) would be an outright position in either EUR/USD or USD/CHF depending on the combinations in question.

For example, if one were Long EUR/USD and Long USD/CHF (an “a” position), then executed a Long EUR/USD and Short USD/CHF (a “c” position), the net result would be a double long EUR/USD as the two USD/CHF positions would cancel each other out.