Friday, July 16, 2010

Does Hedging (on the same currency pair) Really Exist ? A Look at Position Holding in Forex Trading

One of the things I consider the funniest about forex traders is that they seem to have a strong opposition against the removal of "hedging" from their trading capacity. However few of them do realize that the traditional hedging we have seen where you buy and sell a given currency pair at the same time is merely and illusion and that in reality it doesn't exist or -for that matter- make any real sense. On today's post I want to talk about the concept of hedging, why it simply doesn't exist in reality and why any strategy that uses this concept can be implemented without its use. After reading this post you will understand better that hedging a currency pair by having open long and short positions at the same time is not possible in the real market and you 'll see how you can actually understand what you are doing when you have this on your account and how it can be implemented within your strategy to have the exact same results without ever having more than one position opened per currency pair.

What is hedging after all ? In general it refers to the taking of opposite positions with a certain degree of correlation that offers some protection against side movements in the market. So for example going short EUR/USD and short USD/CHF is bound to guarantee some protection against variations in either currency pair since they are heavily and negatively correlated. However since the correlation is not 1 the actual effectiveness of this hedge depends on market conditions and - when correlation is temporarily lost - such hedges become extremely dangerous.

However, when people in the MT4 community refer to "hedging" they generally talk about having a long and short position opened at the same time on a currency pair. For example they open up a long on the EUR/USD at X price and then a short afterwards to cover up their loses or to "fix" some of the profit level they have achieved. Many traders who are not familiar with how the market works consider hedging absolutely vital for their success and the removal of this feature seems to be extremely unacceptable.

When we look close having a short and a long trade opened on the same pair is merely an illusion. What you are doing is buying and selling the same contract so if you were actually carrying out currency exchanges (of physical currency) you would have done the same exchange twice and ended up with what you started with (your ending net positioning is 0). It doesn't actually make sense if you think about it and the way it has been implemented in MT4 is practical in some ways but very misleading in others.

As a matter of fact, any hedging strategy can be implemented EXACTLY in the same way without ever having two positions opened in the market. For example if you bought USD/JPY at 85.54 then you want to enter a short position at 84.54 then exit the short and the long at 86.54 the same effect would be realized if you closed the long at 85.54 because closing the long is indeed what you would be doing in reality if you entered a short. The later point where you exit both the long and short is irrelevant since your net positioning from the open of the short is 0.

Case 1 ( Buy 85.54, Sell 84.54, Close both 86.54)

Long Result = 86.54-85.54 = 100 pip profit
Short Result = 84.54-86.54 = 200 pip loss

Net Result = 100 pip loss

Case 2 (Buy 85.54, Close 84.54)

Long Result = 85.54-84.54 = 100 pip loss

Net Result = 100 pip loss

So in summary it is now evident that the current "short and long hedging ability" in metatrader 4 is simply an illusion and that any strategy can be implemented which currently relies on this feature simply by taking into account the net positioning of the account. When shorts are entered they close longs and when longs are entered they close shorts. In the end this leads to the exact same effect as we would have had if we had simply opened all the short and long positions simultaneously since what matters is merely our net positioning in the market. This is the approach that really makes sense and falls in line with what would happen in a physicial currency exchange.

To sum it up, if you currently have a portfolio trading on the same instrument or if you are trading a system that opens longs and shorts on the same currency pair, don't worry about hedging as you can always implement your strategy using a net positioning approach, something we will all have to do once we move entirely towarsd metatrader 5.

If you would like to learn more about my journey in automated trading and how you too can code likely long term profitable systems using reliable trading tactics please consider buying my ebook on automated trading or joining Asirikuy to receive all ebook purchase benefits, weekly updates, check the live accounts I am running with several expert advisors and get in the road towards long term success in the forex market using automated trading systems. I hope you enjoyed the article !

2 comments:

Andrea said...

Hi Daniel,
but suppose you have two trading system TS1 enad TS2 that works on eurusd with different strategies.
TS1 go long eurusd at 1,30 stop loss 1,28 and take profit 1,36.
Ts2 go short eurusd at 1,29, stop loss at 1,31 and take profit at 1,25. the eurusd is at 1,295. then the eurusd go up to 1,31, the first order is triggered and TS1 is running, with correlated orders to sell at 1,28 or 1,36. Suppose the eurusd go to 1,2880. the order of TS2 is triggered and Ts2 is running with correlated orders to buy at 1,31 and 1,25. finally, the eurusd go to 1,36. first the Ts2's stop loss is triggered at 1,31, then the Ts1's take profit is triggered at 1,36. we loss 200 pips with Ts2 and gain 600 pips with Ts1. net gain 400 pips. but without hedging, whe have a long position triggered at 1,30, and short position at 1,29 with a loss of 100 pips, because the correlated orders of TS1 and TS2 is cancelled.
i hope you understand my thought.
thank for your articles

Daniel said...

Hi Andrea,

Thank you for your comment :o) The problem is that you are not doing the conversion right. The SL of the short at 1.31 is in fact the taking of another long so here is how it would go :

Price at 1.295

Move to 1.31 triggers TS1

Move to 1.28 closes TS1 since we are selling (trigger of TS2 in hedging)

Move to 1.31 triggers the entering a long (because it is where we would be exiting a short (a.k.a buying)

The end effect is a 400 pip profit as with your hedging strategy. As you see the key is to look at it with a net positioning criteria. Exiting a long is simply selling, exiting a short is simply buying.

I hope this answers your question :o) As I said on the post, EVERY hedging strategy can be viewed through a net positioning criteria (which is the real way it works anyway).

Thank you very much again for your comment and kind words about my articles :o)

Best Regards,

daniel

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