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Best Hedging Strategies - 4 pillars of Profit
Hedging strategies help traders mitigate risks and
protect trading accounts from losses. Discover the best
hedging strategies to profit from forex. 6 May 2010 was a
normal day for the markets. In the UK, residents were
going to an election while in Wall Street, the only
concern among traders was the Greek debt crisis. Then, in
the afternoon, something unusual happened. All of a
sudden and without any major news headline, US markets
tanked with the Dow shedding more than 1,000 points. This
event is now known as the flash crash.To get more news
about WikiFX,
you can visit wikifx.com official website.
A similar decline in the worlds markets happened in
January 2015 when the Swiss National Bank (SNB) unpegged
the franc from the dollar. It was a surprising move
because no one expected it.
Those unexpected events are not common but when they
happen, traders and investors lose billions of dollars.
Unlike other major events such as Brexit and global
elections, no one can predict when these events will
happen. This brings the need for proper risk management
strategies in anticipation for such happenings.
A good way to minimise the risk is through hedging.
Hedging is the practice of minimising risks by opening
multiple trades and benefiting from the spread between
the profit and loss. Here are some of the best hedging
strategies you can use.
Opening two trades of the same security
Opening two trades of the same symbol is a safe way
of hedging the risks in the market. For example, assume
that the EUR/USD pair is trading at 1.1200. After doing
your analysis, you find that the pair could gain 10 pips
and reach the 1.1210. So, you decide to buy one lot of
the pair, with the take profit at 1.1210 level. To reduce
the risks, you can decide to sell half a lot of the pair.
If the trade goes right, your bigger buy trade will be
profitable, but the smaller sell trade will make a loss.
In this case, your profit will be the spread between the
profit and loss of the trade. On the other hand, if the
pair goes down, your bigger trade will make a loss, which
will be offset by the profit on the smaller trade.
Trading the safe havens
A few currencies and securities are regarded as safe
havens. The assumption is that traders tend to move to
them when risks increase. The Japanese Yen is regarded as
a haven because of the massive external treasuries the
Bank of Japan (BOJ) holds overseas. It is the second
largest holder of US treasuries after China. For this
reason, the yen always gains even when North Korea fires
missiles above Japan.
The Swiss franc is also regarded as a haven partly
because of the stability of the Swiss economy and the
strength of the Swiss financial system. A study by a
group of economists from Bundesbank for the period
between 1986 and 2012 found that the Swiss franc tended
to appreciate during periods of increased volatility.
Multi-asset correlations
Another way to hedge against risk is to apply the
concept of correlations. This concept emerges because of
the various relationships that exist between different
assets. Closely correlated assets move in the same
direction while inversely correlated assets usually move
in the opposite direction.
A good example of historically inversely-correlated
securities is between the US dollar and gold. Gold is a
metal used mostly for investment purposes and is always
quoted in dollar terms. Therefore, when the dollar rises,
gold tends to fall and when the dollar falls, gold tends
to rise. Between January 2018 and mid-August of 2018, the
dollar index had gained by more than 5% while gold had
fallen by more than 4%.
Near-perfect correlations happen in other securities
too. For example, because of the close relations in crude
oil supply, the price of Brent – the global benchmark –
and West Texas Intermediate (WTI) move in a similar
direction. In the period above, Brent and WTI had gained
by about 7%.
Currency imbalances create good hedging opportunities
for traders. In the case of crude oil, a bullish trader
can buy the expensive Brent futures while selling the
relatively cheaper WTI crude. If the price of oil moves
higher, the Brent trade will be profitable while the WTI
trade will move lower. The profit will therefore be the
profit of the Brent minus the loss of the WTI.
The same strategy can be used in inversely-correlated
pairs like gold and the dollar. A trader bullish on the
dollar can hedge the trade by selling short gold
futures. An easy way of finding correlations between
securities is to fill their closing prices in Microsoft
Excel and then to execute a correlation function.
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