Thursday, May 1, 2008

Hedging Strategy

Hedging is one strategy that every trader should learn in forex trading. This trading method will be able to reduce your losses in case of break-out and also enable trader to trade at any moment without waiting. Therefore you don't have to wait to open position and regardless whether you are opening position on the right place or not.

How hedging work?

The idea of hedging is derived from the mathematics of correlations between the currency pairs where each of the currency pairs will affect each other whenever it moves. For some pairs I.e. EUR-USD and GBP-USD usually fluctuate in identical manner which means that when one of the pair moves the other pair will move in the same direction and vice versa. This is called positively correlated pairs.

Other pairs such as USD-CHF and EUR-USD move fluctuate in the opposite direction for example if the USD-CHF move up then EUR-USD will move down and vice versa. This is called negatively correlated pairs. See correlation table at Mataf.net

Traders utilize these correlations by playing almost like a zero sum game where it cancel profit and of course at the same cancelling losses as well. For example if you buy/long EUR-USD and sell/short GBP-USD and both of the pairs is going up, so you will make profits from the EUR-USD and losses on GBP-USD. This will cancel each other so you will end up zero profit.

The same theory applies when you buy/long both EUR-USD and USD-CHF. As these pairs are negatively correlated so EUR-USD will go up and USD-CHF will go down. Therefore you are profiting from the EUR-USD and losing on the USD-CHF resulting in zero profit.

The explanation about zero profit/losses is only a theoretical assumptions considering if only the pair always perfectly moving in the same amount of volumes and constantly in its correlated direction. However this is not the case in real life trading as there are times that one of pair will move in different volumes to its correlated pairs. And certain occasion there are times that the correlated pairs may switch direction for example EUR-USD move up and GBP-USD move down (negatively correlated) or EUR-USD move up and USD-CHF also move up (positively correlated). It is because of these factors that make profit for traders.

USD-CHF hedging

EUR-USD hedgingThe above candlestick charts show that USD-CHF and EUR-USD move in different amount of volume. Therefore if you are buying/long for both pairs you will end up profiting from the excess pips on the EUR-USD and losing some from the USD-CHF.

Trading Strategy

In order to make the best setup, it would be better if the trade execution is using automated trading software. You can find this only from those who are good in Meta trader programming languages as they used to create automated indicators and trading execution templates. The idea of using automated trading software is to make automatic execution that will simultaneously open position for two pairs at the same time. This will avoid wider gap of discrepancies between the two pairs when executed. As if you are using manual execution you might get wider gaps of pips differences which can result in losses.

Secondly you need to find identify pairs which are smaller pips spread such as EUR-USD and GBP-USD or USD-CHF and EUR-USD or EUR-USD and EUR-GBP. This will help you to avoid wider gaps of pips difference that can make substantial losses.

Advantages of Hedging

  1. You don't have to find any strategic place to open position. As long as you can execute simultaneously at any place for two pairs at the same time just leave the market alone decide. Even thought in the first place you make losses eventually there will be times when it will make profit.
  2. Losses are reduced as the correlation works.
  3. You don't to sit down and wait for your profits as you can leave the system work itself and eventually at certain time it will make profit
  4. You don't have to analyze the market thoroughly including fundamentals or technical whatsoever.

Disadvantages of Hedging

  1. Profits are relatively small due to the cancellation process from the correlation pairs as one profits will be cancel out by another losses.
  2. There are still possible losses even though it is small.

In conclusion many professional traders have made successful trading from hedging especially those who play big money and fear substantial amount of losses. They hedge the market to harvest small profits consistently without fear of big losses. This is one of the most important strategies in forex, as in case you are getting tired of analyzing the market with all the complexities of technical and fundamental involve. Therefore hedging is one solution to save your day in trading. Try it on demo account for example buy/long both EUR-USD and USD-CHF and see later you will make profit at least 2 or 5 pips lol ;). There is no question about it that this system work very well.

More about currency correlation: by Kathy Lien Chief Strategist at FXCM Using Currency Correlations To Your Advantage

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