Forex Hedging

Real Source: forextradingzone

There are a number of forex dealers, dare I say even the majority, who allow clients to practice what is commonly referred to as “hedging” in the forex. What this means is that they allow clients to open both long and short positions in the same currency pair, at the same time. Other dealers, on the other hand, automatically close your positions when you enter orders that are exactly opposite to your open positions. There is an ongoing debate among retail traders about whether the practice of “hedging” is useful or not. There are traders out there who swear by “hedging” and others who think it is absolute bollocks.

First off, let’s differentiate this type of hedging from hedging in other markets.

“In finance, a hedge is a position established in one market in an attempt to offset exposure to the price risk of an equal but opposite obligation or position in another market.” (Wikipedia)

An example of this would be someone who believes in the inherent weakness of the Canadian dollar (CAD), but is afraid that escalating violence in the Middle East may push oil prices up. Since CAD has been known to have a fairly strong positive correlation to oil, the investor decides to sell CAD (long USD/CAD) based on his belief that the CAD fundamentals are weakening, but he hedges this position by buying some oil. This way, if oil does spike, driving up the value of CAD, he will lose out on his short CAD position, but this loss will be somewhat offset by his long oil position. Note that hedging is not meant to eliminate the risk, but only to mitigate it. It is a form of insurance against overwhelming loss. What it does, if done properly, is to smooth out the equity curve of a portfolio, which has benefits which are beyond the scope of this article.

The careful reader will notice immediately that the last words of the definition above read “in another market”, which automatically invalidates the buying and selling of the same currency pair as a hedge. There is no other word to describe this practice however, so you will see it in quotes whenever I refer to it, to differentiate it from the real hedging described in the example.

So we have determined so far that “hedging” is not the same as hedging. In order to go further, we should also define several other terms:

Equity – specific to a retail forex account, this word describes the “value” of the account at the present time. It is calculated by taking the total value of all open positions in the market and adding that value to the account balance. For example, if you have a $10,000 account and one open position that is currently losing $1,000, your equity is $10,000 - $1,000 = $9,000. If you have open positions, this value fluctuates every time your positions do. If you were to liquidate all your positions at current prices, your account balance would become equal to your equity.

Balance – the amount of money you have in the account as margin. This amount varies only when positions are closed, but is not a good measure of the total value of your account, as it does not account for open positions. To judge the value of an account, equity should always be used instead of balance.

Understanding the above terms is crucial in judging whether “hedging” is beneficial or not, since they will be affected differently when a “hedge” is applied.

So what does happen when a “hedge” is applied? When an exact “hedge” is applied, meaning that you buy and sell the same amount of the same currency, your net position in the market is zero (you are market neutral). You are buying and selling the exact same thing at the exact same time, so it doesn't matter which way the market moves, the gain in one trade will be exactly offset by the loss in the other trade. The only thing that has happened is that you have paid your broker the commission or spread payment twice. This is also true of "hedged" trades which are not exactly equal. If you buy x units of EUR/USD and you simultaneously sell y units of EUR/USD, then your net position is x-y units of EUR/USD, where a negative value indicates a net short position and a positive value indicates a net long position. You can see from here that if x=y, then we have a net position of 0. Let's study 2 cases where one trader uses the "hedge" option and another trader simply closes his trade in order to become market netural, that is, to close his positions.

Case 1: No "hedging"

$10,000 account

Open 1 mini lot (10,000 units) long EUR/USD at 1.2500/02 (1.2502 is ask price, so this is the one used)

EUR/USD goes to 1.2000/02 and we exit (1.2000 is used)

Total loss of 0.0502 or 502 pips

Total loss is 502 x $1 = $502 ($1 is the EUR/USD pip value on a mini lot)

Equity = $9,498

Case 2: "hedging"

$10,000 account

Open 1 mini lot long EUR/USD at 1.2500/02 (1.2502 is ask price, so this is the one used)

EUR/USD goes to 1.2000/02 and we enter a 1 mini lot short (at 1.2000)

Now we are market neutral (our equity does NOT change regardless of where EUR/USD goes). We have, in effect, closed our position.

However, our platform says we have 2 positions open:

1. -502 pips = -$502
2. -2 pips = -$2 (due to spread)

Equity = $9,496

Then price continues downward to 1.1000 and we have:

1. -1502 pips = -$1502
2. +998 pips = $998

Equity = $9,496 (unchanged because we are "hedged")

Adding our two positions together yields an account equity of -$504. Compared to Case 1, where we lost only $502 and had no trades to worry about any more. Now we have lost $2 more due to paying an extra spread, AND we still have to worry about having open positions.

It may not seem like much, losing 2 pips more than in case 1, but you are in effect doubling your spread, and forex is not a game where you can afford to throw away perfectly good pips. Add to that the fact that you still technically have 2 trades open, and the inherent risk of slippage or other execution problems when it comes to trying to close these 2 trades, and you have another possible disadvantage.