Hedging Types Explained
As a money management tool, hedging is highly regarded as one of the most popular techniques to protect a trading account from potential swings that might affect a portfolio. A trading account can be partially or fully hedged, and, based on the hedging technique used, there are many possibilities to profit from this money management technique. Hedging is not allowed in the United States as it is a tool that only increases the risk exposure in a trading account. While this may be true to some extent, it is in no way different to other money management rules that should govern trading. The only thing that is different is the trader’s perception of a hedged account. This has much to do with the aspect of trading psychology many traders lack the most.
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Hedging refers to a trading account that has both long and short positions for the same financial product. In the case of the Forex market, currency pairs are involved. To give you an example, in a totally hedged trading account, the volume is equal on both the long and short sides of the same currency pair. Therefore, at one moment in time, it is possible to have two lots on the long side of the EUR/USD pair, and two lots on the short side of the same currency pair. At first glance, this seems like a stupid thing to do; I mean, why trade the same pair in both directions, as eventually one is going to end up in a loss, right? The answer comes from the fact that the market does not move in locked steps, but in waves, and corrections are expected after a swing higher or lower happens. Another answer is the fact that some trades may be the result of a specific timeframe analysis, and others the result of a different one; and both might make sense at a specific moment in time. What is different is the time horizon, or the moment at which the take profit is supposed to be reached.
Types of Hedging
Based on the above, there are three types of hedging. All of them are useful at one or other moment in time, and hedging a portfolio against potential headwinds is vital for long-term success.
A fully hedged account has at one moment in time the same long and short positions opened. This makes sense when traders use the same technical analysis approach from a top-down perspective. A top-down analysis is when traders start with the longer timeframes, like the monthly and weekly charts, and come down to the shorter timeframes like the daily and the hourly charts. For all of the timeframes the same analysis is used, typically an indicator-based type of analysis. That being said, let’s assume that RSI (Relative Strength Index) bullish or bearish divergences are being looked at on those timeframes. It is therefore extremely likely that the weekly chart will show a bearish divergence that hasn’t reached take profit yet, while the daily chart will show a bullish one forming in the meantime. By taking both trades, the trader is profiting from both divergences, while the account is fully hedged. The moment the bullish trade, or the long one, reaches take profit or is closed, the short one remains valid and the trading account’s balance will increase if prices are moving lower.
As the name suggests, a partially hedged account is one that has both long and short trades of the same currency pair, but with a different volume. This may be the result of a trader’s perception regarding the risk involved for any specific trade. It may be viewed that the risk of being heavily positioned in one direction is too big, and a partially hedged strategy is convenient. In doing that, the margin in the trading account is freed, and it can be used to trade other currency pairs/set-ups.
Another popular hedging technique that has no limitations or boundaries worldwide is correlated hedging. The main idea behind this technique is that a specific open position in the trading account is hedged with another trade of a product that is correlated with it. It doesn’t really matter whether it is a direct or inverse correlation. What matters is to know what financial instruments fit into this category. The currency market is formed out of currency pairs that are grouped based on the importance of the world’s reserve currency, the US Dollar. In other words, if the reason why, for example, you bought the EUR/USD pair was because you were expecting the US dollar to be bearish in the period ahead, then the same thing should happen with all US dollar currency pairs. This brings uncertainty, as overtrading is a big threat. After all, it means that if you buy the GBP/USD pair, it is like adding a new EUR/USD long, because the two pairs are directly correlated. The same is valid with commodity pairs, with the AUD//USD and USD/CAD being inversely correlated. Buying the AUD/USD and selling the USD/CAD pair is overtrading if the reason is the US dollar. Correlated hedging means that on an AUD/USD long trade, a USD/CAD long is recommended as well. In this way, the account is partially or fully hedged, and there are no constraints whatsoever. When the EUR/CHF cross was pegged to the 1.20 level by the Swiss National Bank, the closer the pair moved to the 1.20 level, the more nearly identical the moves between the EUR/USD and the USD/CHF pairs were. This meant that the only way to trade the two major pairs was not in the same direction, as the result would be a totally hedged account. By the time the peg was dropped by the SNB in early 2015, the EUR/USD and USD/CHF correlation had started to decrease.
In the same category, one can talk about the now-famous USD/JPY and US equities correlations. Most of the time there is a direct correlation between the two, and this means that when the US equities, like the DJIA or SPX, are rising, it is not wise to be short with the USD/JPY pair, as the likelihood is that it will rise as well. Coming back to the limitations that US traders have when it comes to hedging, it should be mentioned that they refer only to the situation when hedging is full or partial. Even this can be avoided, by simply having more than one trading account, and taking different positions in different trading accounts.
The above are only a few examples, and the purpose is to highlight the importance of these hedging possibilities. Hedging can be realised in various ways, starting with volume and ending with the actual financial product that is traded, and it is a tool that must be part of any trader’s money management rules.
Other educational materials
- Pennants as Continuation Patterns
- Price and Time – The Holy Grail in Trading
- Two Ways to Use Gaps When Trading Forex Markets
- Trade Forex with Fibonacci Retracement Tool
- Trade with Risk-Reward Ratios
- Bullish or Bearish Setups Using Stars
Recommended further readings
- “Macroeconomic sources of FOREX risk.” Wickens, Michael R., and Peter N. Smith. Univ. of York Econ. Discussion Paper 2001/13 (2001).
- Exchange rate dynamics and Forex hedging strategies. Dash, M., 2013. Investment Management and Financial Innovations, 10(4).