I have a question regarding hedging that has been in my head for several months and that I’ve decided to take the time to ask.
As far as I understand, companies around the world use hedging as a way of not losing value in their international transactions because of currency fluctuations.
But for us traders I don’t quite understand how to get a benefit from it. I’m curious about how you guys use it and what benefits you find.
I mean with my little understanding about the subject, I guess that while hedging you totally eliminate any possibility of profit as well as a loss, plus you’ve already paid twice as much for spread than in a sigle trade, so you’'re carrying negative numbers already to start with.
Then, I’ve read how some traders use it while confirming the direction of a trade, and once it’s confirmed, they close the negative position and let the right one run. But, why not let price confirm direction without any trade open and just open a single trade when the movement is confirmed instead? Wouldn’t that be cheaper?
That’s how I see it, but I know that there are more implications and that there should be very good benefits of hedging. So if anyone wants to share them, thanks!
A hedge with the same pair buy and sell is not a good idea.
A hedge in a highly correlated pair or basket can be used a little better as no pairs are 100% correlated and the little swings each pair make can be used to exit the hedge and beat the spread. Now is this better then just closing out and reentering at a better price? maybe maybe not sometimes it works and a trade can run until it comes back around and the hedge can be exited at no loss, sometimes you eat it:D.
This can be done with a US broker as its not a hedge with the same pair.
You are spot on. As controvertial as it is, the NFA banned hedging for good reason. The implementation of such ban is a different story…
I used to be a die-hard “no-loss” hedge grid trader and I fully believed in what I was doing until a friend sat me down and explained with pictures what I was doing.
Feels good no to be alone, lol. Plus to me it looks complicated. A while ago (better said, a long time ago) I tried hedging on a demo account, just to know how it works. Needless to say I was losing faster, lol, but back then I didn’t even have a system, so that surely is recipe for disaster. It was demo anyway, but I didn’t find a reason to go deeper on the subject.
Thanks for answering Shr1k! Really interesting. I don’t know if you hedge some of your positions or have some experience in the subject, but does it really help minimse the risk? Or what would be the purpose of doing so. Thanks for dropping by.
Thanks Kenny! It’s nice to hear someone else’s experiences. What exactly did your friend show you? I mean what was his/her point?
You have to be careful with this kind of hedging. For example, I see traders thinking to hedge a long EUR/USD with a long USD/CHF. Sounds good in theory since the two tend to work in opposite directions. Here’s the rub, though. When you put those two trades on you basically end up long EUR/CHF because your USD positions more or less net out, leaving you with a long EUR exposure and a short CHF exposure.
I agree with the senior traders above. Forget hedging as a strategy. I’ve tried all sorts of hedging strategies, including using options and futures markets, and they all reduced my profits more than protected me against losses. In my opinion, the best strategy to protect against losses is to simply exit when the price action is moving against you. It’s simple, effective, and really cheap since you can always re-enter a good trade for just a few pips spread if price action moves back into your favor.
Thanks Kenny! It’s nice to hear someone else’s experiences. What exactly did your friend show you? I mean what was his/her point?
He showed me that there is zero difference between closing a position and hedging a position, except when you hedge, you will pay an extra commission and you will expose yourself to extra swap.
By way of example, a typical hedging scenario would involve 1.0 lot BUY that goes wrong. When the trade is far enough down eg 25 pips, you would open 2.0 lots SELL. Your net exposure is 1 Lot SELL and you would have paid commission on 3.0 lots trade plus the future swap…and on many brokers, the swap is negative for both sides of the trade.
Had you simply closed the trade and opened a trade of 1.0 lot SELL, your exposure would be the same but your total commission would have been for 2.0 lots ie 50% less.
Not only are you paying extra to hedge, you have locked up equity that is now no longer available for any other profitable strategy that you may have.(There is a caveat here…I know some brokers require zero margin for a hedge but most would require margin for 2 of the 3 lots that you have open).
The above diatribe refers to hedging specifically as a trading strategy, not when you have 2 seperate strategies that may have conflicting short term signals and end up in a hedge. Unfortunately this kind of diversity is one of the unintended casualties of the banning of hedging by the NFA.
ok, here’s a crazy idea for how hedging could help in trading. Suppose you enter a hedge at the start of the day with a reasonable TP that is within the usual daily range. During the day price will go up and down, at some point hitting the TP on your buy and at some point hitting the TP on your sell so you get two wins where if you only had one trade you would only have had one win. Now suppose price only goes up or only goes down during the day. One trade becomes a looser but that loss is reduced by the amount of the one trade that becomes a winner.
So by hedging you have increased the amount that you might win during the day and decreased the amount that you might loose.
That sort of straddle play was popular up until 2007 when the volatility exploded. It can work as long as the ranges are relatively narrow and predictable. The risk, however, is that one side gets taken out and the other side remains open. For example, the long profit is booked, but the market never reverses. The short is still open and exposed. It’s basically the same as if you put an order in to buy at your short TP and a sell order in at your long TP. If both get hit you make all the pips. If only one gets hit you’re screwed.
to limit your loss, you would close the loosing trade at the end of the day. Not let them run over multiple days. You could still end up with big losses though, I did say it was a crazy idea. Meaning off the cuff, not well thought out.
On FF, there is a pretty in-depth discussion on why retail spot hedging is utterly worthless. I think they came up with a word for it because it isn’t true hedging, 'nedging.
Totally agree. I should say the scenario I am talking about will increase your risk simply by the fact you have more money in play. The ultimate goal of what I am talking about is taking on more risk for a short time to save a bad position. Some times it works. Anyone that has been doing this for a while will know when you open a trade you take on risk period. If you are in a situation where your MM and risk tolerance will allow more open trades correlation hedging is an option you have. Its not risk free or less risk.
ok, here’s a crazy idea for how hedging could help in trading. Suppose you enter a hedge at the start of the day with a reasonable TP that is within the usual daily range. During the day price will go up and down, at some point hitting the TP on your buy and at some point hitting the TP on your sell so you get two wins where if you only had one trade you would only have had one win. Now suppose price only goes up or only goes down during the day. One trade becomes a looser but that loss is reduced by the amount of the one trade that becomes a winner.
So by hedging you have increased the amount that you might win during the day and decreased the amount that you might loose.
Ok, here are 2 EA’s for you to examine the hedging debate. I created 1 EA that trades your above quoted idea. You can elect to close the trades at the end of the day, or leave them to run.
I created a second EA that trades the same stratgey, but without entering a hedge. Instead of opening 2 trades(long & short), it lays a limit order at the point where you would have taken your profit on the hedge. At this point you have, in fact, made no profit, since you have a hedge trade that is negative to the same amount that your profit is for the closed trade. Your exposure to the market is then 1 trade in the direction of the negative trade, which is the same as the limit order.
Look at the journal after running the backtest…the last line will show you the calculated commission & swaps.
My point here is the following :-
[ul]
[li]There is no hedge strategy that cannot be written as a single composite order;
[/li][li]The hedge trade incurs double the commission charges;
[/li][li]the hedge trade incurs massive swap penalties
[/li][/ul]
Having traded long term hedge strategies, I consider swap to be the silent killer.
Whats the difference between ’hedging’ and ‘corelation trading’. What would you call the E/$ and $/F situation above? I think hedging is when one longs and shorts on the same chart simultaneously. Correlation trades can be a hedge since buying and selling happens at the same time though different charts, right? The scenario with two pairs isn’t strict hedging and discussing it too much will drag things the wrong direction, but here it is.
I used to ardently do the E$/$F thing back then, but stopped for other strategies. Check out the diag below. The method went like;
i). Enter instant long (L0) on both E/$ and $/F pairs, with take profit at +100p, (i.e. points TP0). It would be like hedging on Euro/CHF, but not quite the same.
ii). Immediately enter long stops, again at +100p (LS1) on both charts, with take profit for these at a further +100p, +200p from origin.
iii). For the gaining pair, in this case E/$, enter long-stops every +100p with their take profits being +100p, such that each entry long is hit as TP for the lower stair is being hit.
iv). For the loosing $/F pair, enter long-limits every -200p.
v). Average the whole loosing pack of trades as they accumulate, and place their TPs at this average / break-even point.
For the gaining pair, in this case E/$, TP0 should be hit (at time A), books +100p net, with the loosing $/F pair being at -100p floating. Here, the first long stop (LS1) is hit for the gainer E/$. Its take profit (TP1) is hit at time B at a further +100, +200 from origin, while the looser pair packs in another loosing trade with entry long-limit LL1. In a protracted trend, the sequence of trades packs in with pip results as shown in the table attached below. Notice that BE is hit closing most previous losing positions, and now booked profit exceeds the floating P&L or drawdown by a nice difference, and that the floating drawdown is not yet booked into the account.
vi). As the prevailing trend(s) reverses, at worst you are left with a long whose TP got missed barely (*TP4) on the previous E/$ gainer-now-looser, with 0p floating profit and loss at period E, -100p floating at F, and -200p floating at G. On $/F now gaining, we will have no trade open as yet, i.e. the new loosing E/$ pair will already have a -200p position open, and none on the gainer. It should be such that we would’ve placed an entry long-limit for loosing E/$ with TP= +100p every -200p, and an entry long-stop for the now gaining $/F with TP= +100 every +100p.
Now that’s the theory. On charts, notice that the Coefficient of Correlation between the two pairs is not perfectly negative (-100) but slightly around -95, which means;
• E$ is ‘faster’ than $F in that it covers a larger daily range and by the time $F clears 100p, E$ is a few pips ahead measuring from same time of entry to exit.
• Also, the value of a pip move for a std. lot for E/$ is $10, while for $/F is $ 9.5, $8.34 or so depending on math.
In other words, there is sometimes a significant difference in the change in floating P&L between the pairs for same-size same-time trades ($/F lagging behind $0.5, or is it $1.66 per pip per std lot). To realize reasonable return on account balance with the method (like me) and coupled with the need to rake in more, one ought to use trade sizes larger than would be for non-hedged trades. This, however, can work to your disadvantage as it depletes margin at increasing rate irrespective of whether the trades are doing good or not.
If we are to draw the new profit table for practical trades, we can see where to take out parts of the trade(s) for the profit difference in the float as it goes. Another major thing to ensure is that the whole thing doesn’t fall apart prematurely or develop cracks (and there’s method in how to seal the cracks) by one level hitting on one pair while missing on the other pair. Do you make it hit manually? Would an EA know to do that? That’s another post.
My point exactly? Hedging gives the chart trader an immense advantage in that he gets home alittle tipsy Sunday night and places the trades right then, no thinking. He’s in perpetual trading while the market slaughters bulls and bears all week, no guessing for market direction. The catch: he has to carefully man the hedge without over-manning it and has to learn the schematic for the all the levers. Secondly, even the Tower of Babylon could only get so far and when it had to come down there were two options to choose from; sudden demolition or an organized disassembly. Given one account, one is better off either sticking with this method only or abandoning it altogether depending on skill level. I abandoned it. If everyone were to figure out a particular way to hedge, then that market would collapse? The whole thing begs more indepth research and consideration of new ways, like different brokers?
Only in retail forex trading is the term hedging used to mean taking opposing positions in the same instrument. That sort of move outside of retail forex is called offsetting or having no position. When I try to explain the retail forex definition to pros or traders from other markets they think it’s the most ridiculous thing in the world, and with good reason.
Hedging is the act of taking a position in some other market or instrument to protect against one or more exposures of an existing position. For example, someone long Google stock may short the NASDAQ index futures as a hedge against a general market decline. In forex we can call a long USD/CHF trade against an existing EUR/USD long as a dollar hedge, as it effectively neutralizes most or all of the trader’s dollar exposure. The problem, as I noted, is that it introduces a CHF exposure. In other words, hedging forex positions using other forex pairs isn’t a clean thing.
I used to ardently do the E$/$F thing back then, but stopped for other strategies. Check out the diag below. The method went like;
These sorts of grid trade strategies were quite common during the middle 2000s when the forex markets were much less volatile and range-bound. When things started getting more volatile and more directional in 2007 those strategies went up in smoke. I’m sure they cost some folks a lot of money.
Now that’s the theory. On charts, notice that the Coefficient of Correlation between the two pairs is not perfectly negative (-100) but slightly around -95
This is because EUR/CHF actually trades in its own right, not just as a mathematical relationshp between EUR/USD and USD/CHF. A quick look at some of the spikes in the cross over the last year when the SNB has intervened in the Swissy makes that quite clear.
Consider the following scenario where a trader is buying limit on the way down expecting a rebound in price - like averaging down. A dangerous strategy by itself.
Instead of going long on the trend down in price, why not go long/short on the same pair - TP on the shorts, opening another long/short, and when the rebound occurs close out the longs - providing overall positive.
I’ve seen this under the threads of Grid Trading which appears to be sound on pairs suited for it - eg. GBP/JPY.
Has anyone here tried it and what were the results. A visual backtest appears to confirm it will, however I haven’t demoed it yet with an EA.
Let’s walk through an example of this. The market drops from 100 to 90 and you think it’s going to rebound, so you go long and short at 90. If the market does rally back, you make nothing until you close the short because for every point gained on the long there’s one lost on the short.
OK. What if the market falls to 80? Following your strategy let’s say this is where you cover your short to book 10 points and add a new long/short. So now you’ve got 2 longs, one of which is 10 points in the red, and a short. Net it all out and it’s the same as if you entered one long at 80. If the market falls that long will lose money and your account will too. If the market trends down, no matter how many times you add another long/short at a lower point you will eventually get margin called and blown out. In fact, all the extra longs and shorts could just make that margin call come that much more quickly.
The only time you can make or lose money is when you have a directional exposure. Having a long offset (“hedged”) by a short by definition means you can neither gain nor lose while that position is on.
IMO, you should only bother with hedging if you are a long term trader.
For example, you placed a buy order on USDJPY but it’s just not going your way even though you are “sure” it will eventually turn around due to fundamental reasons but in the meantime it has continued on it’s downtrend. You could consider placing a hedge on a different instrument to sell perhaps the dollar index or some other $ pair. At the point you do that you automatically lock in the loss though. If your hedge turns a profit, then you could set the SL to break even and hope then when price comes back up it closes out the trade and continues up.
What some people do is use options to do this, again, a losing way to trade for most newbies as it is a complex matter.
You could also open up half trades as a hedge while confirming direction, all depends on your strategy. For the most part it’s not a good way to trade and not without a few years experience across the markets.
