Forex Trading: Is There an Advantage to Hedging?
05/03/2013 9:00 am EST
To be successful in forex trading, you need to have solid risk management skills, and one way to manage position risk is through hedging, as Marc Principato of SMB University Forex Training Program explains what is involved in hedging.
There was a time (before 2010) when you could open a forex account with any US broker and have the ability to hedge your spot forex transactions in the United States. Residents outside the US still have the ability to hedge their forex positions. On the surface, hedging sounds like the ideal situation: After taking your initial position, if you are wrong, simply hedge it instead of stopping out with a loss. Sounds like a win-win situation right? Those of you who have attempted to do this know that there is still the element of market timing involved. When do you put on the hedge exactly? When do you take it off? Is there any advantage to doing this?
In my opinion, hedging can be helpful if you have a strong understanding of your bigger picture and relative conditions. For example, let’s say you want to take a EUR/USD trade long as a position trade. This means you have done your analysis and believe that it is trading at a very significant support level. On top of that, it is showing signs of stability and you are able validate your long on a smaller time frame. You begin the trade and as it goes your way, you add some more size to your position. Remember, this is a position trade and you are trying to capture a broad move over a number of days or weeks. You know how much noise is involved. This pair can fluctuate hundreds of pips over this period. So how can you ride this rodeo bull without falling off?
The answer is: When a short signal appears on an intraday time frame, be ready to put on a temporary hedge. For example: Your forex pair reaches an intraday high but you hold because you know it still has a lot more potential. After a few hours, it attempts to break the high again, but fails. This time it generates a short signal. Now what? Get out of some of your position too early? Or put on a short hedge. The short hedge here serves one purpose: piece of mind. Instead of getting very anxious while you watch your profits evaporate and hope that it’s just noise, you can look on with ease. If the selling is sharper than you thought, you have nothing to worry about as you make it back on your hedge. If the selling is light and leads to a buy signal within a nearby support area, guess what? Take off the hedge whether it’s a small profit or small loss.
NEXT PAGE: How a Hedge is Similar to a Stop|pagebreak|
Keep in mind putting on and taking off hedges come with a cost. If you are doing it with futures, you have to pay commissions, if you are doing it in the spot market, you are paying the spread again. This can add up quickly and this is why you do not want to put on a hedge at every little hesitation in the price action. Also another cost is what I like to call “position wear” and this is when you put on a hedge that you lost some money on and have to take it off at a slightly larger loss. Maybe you took the hedge and it was on a false signal, etc. This is why it is so important to understand what signals to look for and on what time frame. Trying to use a five-minute chart to use for hedge signals is a bad idea if you are trying to carry a position on an hourly time frame.
In my opinion, putting on a hedge is very similar to using a stop. The advantage is it allows you to protect your original position and gives you enough flexibility to ride out broader moves. Some of you may say: That’s nice, but I can’t hedge with my forex broker. Most likely you are a US resident. Let me ask you this: Have you ever considered a broker that allows you to trade both forex and futures in the same account? You can easily hedge a spot position with futures. You just need a strong understanding of the futures contract specifications in terms of leverage and tick value. If you are a beginner, then don’t worry about this, just understand that as you advance in your learning curve, there are more creative ways to manage risk besides using a stop order.
Overall, hedging forex positions can offer unique ways to manage risk in your positions. Whether you use futures, or correlated instruments, you can find ways to moderate your exposure without having to get stopped out all the time. The key is to understand your perspective thoroughly and accepting the costs that are involved in the type of adjustments you will have to make. As you become more experienced you will be better prepared to use creative solutions like hedging to control risk and reduce the anxiety in your trading process.
By Marc Principato, CMT, Director, SMB University Forex Training Program