Forex Trading. Full Hedging, Is It Possible?
What Is Hedging?
It depends who you ask. Traders have lots of different ideas. I hope to dispel some myths in this article. So what is hedging?
I think fund managers have the best answer. After all, of anyone they have to manage risk the most carefully, otherwise they are out of a job.
The way I've heard most fund managers explain it is like this. A hedge is being long in one instrument, while short in a different one that in one way or another offsets some or all of the risk of the long position (depending on what they are trying to accomplish).
Did that make sense? I know. It was rather convoluted. Let's move through some examples. It will make sense then.
The Long and Short of It
It's say you take a long position is EUR/USD at 1.2700. The price drops. With a different broker, you take a short position at 1.2650. Have you hedged your long?
I've met traders who say yes. They say that now there short will make what every there long position loses.
I hate to burst bubbles, but going long and short is going flat. It's the same as having no position on. The only difference is you'll pay the spread twice (a bad thing).
The traders who say that going long and going short is hedging say that when the price moves up they will take the short position off to capture the upward movement are still deluded.
Having a short and long position in the same instrument, and then taking the short one off, is the same as just entering long. That's it. Furthermore, how do you know that the market will continue to move up after you take the short off? If it moves down again will you put the short on again? If you do, you will pay the spread a third time for a single trade. Believe, make this a habit and you find being profitable is tough even if you pick more winners than losers and have great money management.
So, let's take this is a different direction. What if you traded EUR/USD long and went short USD/CHF? Have you hedged against the dollar? No. What you've done is created the currency pair EUR/CHF with two other pairs. You're not hedged; you're long EUR/CHF.
Another clever idea is to go long a currency pair that pays lots of interest, and then to short that pair with a broker that doesn't charge interest.
At first the idea sounds attractive, but it breaks down in theory and in practice. You see, this is the ultimate form of free money. Free money doesn't exist.
Secondly, finding a broker that doesn't charge interest and is honest will be very difficult. And also don't forget you have to pay the spread twice on each order.
So how do you create a true hedge with currencies? You have two tools to use. One way would be with futures. The next subsection deals with the other. The CME has an emini Euro FX contract (symbol is E7). You could be long in the spot market and short in the futures market and you would be hedged. However, the futures contract and a spot contract are not worth exactly the same; so you would not be totally covered.
The last way to hedge is with options. This is also how you can trade without stops safely. Let's say you go long USD/JPY at 116.00. You also go long a put option out of the money with a strike price at 115.50. Let's say it cost you $20.
The price must go up 20 pips (in a mini account) for you break even. You lose the cost of the option if the price doesn't sink below 115.50. If the price does plunge down to 114 say, your put options will be worth a lot. Subtracting what you made on the options from what you lost on your position, you'd find that you only lost 70 pips (the cost of the option $20 plus the difference between your entry and the strike price $50).
You are truly hedged. You only lose the cost of the option if the price skyrockets (and you'll make a bundle on the price moving up so far). On the other hand, the price can sink as low as it wants to, you're loss is fixed.
This gets even better. How often has the price touched your stop taking you out of the market before going your way? With an option as a stoploss, that can't happen. You can ride out a market that wants to stop you out. Your option protects you.
Obviously this is just a quick look at this strategy. If you want to do it, study the concepts behind it a lot more before you try it. Options are an animal all of their own. Know what you are doing, before you do it.