Hedging – What is it and How to Use Different Types of Hedging
As one of the money management tools, hedging is highly regarding as one of the most popular techniques to protect a trading account from potential swings that might affect the 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 by no means different than other money management rules that should govern trading. The only thing that is different is the trader’s perception regarding a hedged account. This has much to do with the trading psychology part many traders lack the most.
Hedging refers to a trading account that has both long and short positions of the same financial product. In the case of the Forex market, currency pairs are being 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 of time, it is possible to have two lots on the long side EURUSD pair, and two lots on the short side of the same currency pair. At the first glance, this seems like a stupid thing to do, I mean, why to trade the same pair on both directions as eventually, one is going to end up in a loss, right? The answer comes from the fact that market is not moving in locked steps, but in waves, and corrections are expected after a swing higher or lower is happening. Another proper answer is the fact that some trades may be the result of a specific time frame analysis, others the result of a different one, and both might make sense at a specific moment of time. What is different is the time horizon or the moment the take profit is supposed to be reached.
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Types of Hedging
Based on what was mentioned above, there are three hedging types. All of them are useful at one moment of time or another, and hedging a portfolio against potential headwinds is vital for long-term success.
A fully hedged account has at one moment of 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 bigger time frames, like the monthly and weekly charts, and come down to the lower time frames like the daily and the hourly charts. For all the time frames the same analysis is being used, typically indicator based type of analysis. That being said, let’s assume that RSI (Relative Strength Index) bullish or bearish divergences are being looked on those time frames. Therefore, it is extremely likely that the weekly chart will show a bearish divergence that didn’t reach take profit yet, while the daily chart to 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 being closed, the short one remains valid and the trading account’s balance will increase if prices are moving lower.
Like the name suggests, a partially hedged account is one that is having both long and short trades of the same currency pair, but the volume is different. This may be the result of 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/setups.
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. Be it a direct or inversed correlation, it doesn’t really matter. 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 U.S. dollar. In other words, if the reason why, for example, you bought the EURUSD pair was because you’re 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 GBPUSD pair, it is like adding a new EURUSD long, because the two pairs are directly correlated. The same is valid with commodity pairs, with the AUDUSD and USDCAD being inversed correlated. Buying the AUDUSD and selling the USDCAD pair is overtrading if the reason is the US dollar. Correlated hedging means that on an AUDUSD long trade, a USDCAD long is recommended as well. This way, the account is partially or fully hedged, and there are no constraints whatsoever. When the EURCHF cross was pegged to the 1.20 level by the Swiss National Bank, the closer the pair moved to the 1.20 level, the almost identical the moves between the EURUSD and the USDCHF 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 total hedged account. By the time the peg was dropped by the SNB in early 2015, the EURUSD and USDCHF correlation started to decrease. In the same category, one can talk about the now famous USDJPY and US equities correlations. Most of the times 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 the USDJPY pair as the likelihood is that it will rise as well. Coming back to the limitations the US traders have when it comes to hedging, it should be mentioned that they are referring only to the situation when hedging is fully or partial. Even this can be avoided, by simply having more than one trading account, and therefore taking different positions in different trading accounts.
The above examples are only a few and the purpose is to highlight the importance of these hedging possibilities. Hedging can be realized 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).