The GotForex Weekly Newsletter – Oct 17, 2008 – What is hedging, Rob? How can it get me closer to my dreams of poverty?

The GotForex Weekly Newsletter

by Rob Booker

If you like to lose money, but you want the pain of losing to last for as long as possible, and then result in a furious ball of exploding pips, then “hedging your trades” is right for you.

In the past few years, I’ve noticed an explosion (metaphorical) of interest in hedging — the act of buying and selling the same currency at the same time.  Not coincidentally, I’ve also noticed an explosion (literal) of scores of trading accounts, as inexperienced investors have locked onto this method of trading and discovered, the hard way, what can go wrong.

What is hedging, anyway?
Why, Rob, are you so down about it? Relax, dude!

I am not writing this newsletter to tell you that you must, or must not, use any specific trading methodology.  Remember that your decisions about what kind of pairs you trade, when you trade them, how you trade them, and what you use to trade them are personal choices between you and … you.

Now let’s cover some of the basics of hedging:

1. For a forex trader, hedging is commonly understood to be the act of buying and selling the same pair at the same time in the same trading account.

2. Equities, options, futures, and forex traders each have different definitions of what it means to hedge. Remember that when you are at a trader’s cocktail party, that you need to get your lingo correct, or you might look a bit wiggidy-whack.

Here are three common examples of hedging:

Example 1:
Joshua is a forex trader, and a major economic report — the Wisconsin Cheese Index — is going to be released in the next 30 minutes.  He is unsure about which way the market is going to go, so he buys and sells the EUR/USD in his account, at the same time, at almost exactly the same price.

Example 2:
Alicia is a forex trader.  She has an open buy trade on the EUR/USD at 1.3800, but the currency pair keeps falling, and she is losing more and more money every day and she is starting to wonder what she should do.  Her friend, Ray, suggests that she simply open a new trade, this time a sell.  Now, for every pip she is losing as the pair goes down, she gains a pip. Wow!  She just kept herself from seeing only negative numbers in her account.

Example 3:
Corbin is a high-powered trader-guy who has really bet big this time, and he’s riding a losing trade.  He mistakenly believes, in his heart, that it will come back.  It’s Friday, and he is worried about gaps and volatility on the Sunday night open — so he hedges his position going into the weekend.

Wow!  This hedging stuff sounds fancy!

You’re right: it is fancy.  And this fancy technique can turn into a cluster-bomb of ridiculous proportions.  Here are some things you need to think about before you start running off and hedging all your losing positions:

1. Think about why you want to hedge.  What are you trying to accomplish?  What will a hedge do for you that you can’t accomplish in some other way?  Does your hedging fit into a method of trading that you have become comfortable with?  Or…
   

2. Are you hedging because you want to avoid a loss?  Many times, people will hedge a trade because they simply don’t want to accept a large loss.  They see themselves down by 20-30% in their account, and rather than accept the fact that they have lost a lot of money, they hedge their trade.
   And then…

3. Remember: if you hedge, you are locking yourself into a loss.  Once you put on the hedge, you are locked into that loss.  You’re going to live with it day and night now.  It’s not going away.  It is going to stare you in the face every time you go to your trading account.  It could become an emotional burden for you.  You could start to focus on getting out of the hedge more than you can plan and benefit from new trading opportunities.  And here’s something about those trading opportunities:

4. Being in a hedge could distract you from those other trading opportunities.  I call this (and I am not making this up) Trader Attention Deficit Disorder, which is a serious condition affecting many hedged traders.  It means that when you are locked into a loss, you can become so focused on the loss and the hedge that you don’t notice other good trades.  If you have a hedge that lasts longer than 4 hours…

5. Being in this hedge will probably cost you interest.  Realize that if you buy and sell the same currency pair at the same time, you are most likely to have a net debit on interest at the end of every day.  For some pairs, this interest payment can add up substantially day after day.

6. How are you going to get out of the hedge?  You’re going to have to pick a top or bottom.  And if you already knew how to do that, you wouldn’t have been in the hedge in the first place, right?   You don’t want to put yourself in a position where you have to practically be a Psychic Friends Network Call Center Manager in order to extract yourself from the trade.  Often times, people will remove one side of the hedge, only to see the pair trade lower (or higher) and then they feel like they have to put the hedge back on all over again.  That’s just an endless cylce of trying to pick a bottom or top. And remember that the wise man said: He who tries to pick a bottom gets a stinky finger.

Fancy, indeed!  There are all sorts of reasons why a hedge, which was intended to solve your trading problems, just brings a host of new challenges to the table. I’m not saying that you should never hedge; I am saying that before you do it, consider what it is that you are trying to accomplish, and get yourself prepared for the consequences that result.

Rob, you just mentioned something about trading economic reports and hedging at the same time.  This sounds like something I would like to do, because I love trading near when economic reports are released.

Well, let’s tackle this issue right out in the open.  Is hedging a reasonable strategy in advance of an economic report?

We all know that some economic reports create a massive amount of volatility.  We also know that it is nearly impossible to predict, ahead of time, exactly which direction a currency pair is going to move after the report.

In the last few years, an increasingly (and alarmingly) large number of forex traders have begun to simply buy and sell the same currency,  at the same time, before an economic report.  Their goal here is to close the losing side of the hedge after the report comes out, and then ride the winning side for sweet profits.

Because I very much overuse numbered lists, we’re going to use letters this time.

1. What happens if the spread increases when the report comes out?  Both sides of your trade could stop out, and then there will be no sweet profit.

2. Are you hedging before the report because you are worried you won’t be able to get in on a trade after the report comes out?  If so, think about this: what makes you sure that you will be able to get out of the losing trade after the report?

3. Did you increase the size of your trade because the hedge made you feel more confident?  Please don’t believe that simply because you are hedged, you are in a much safer position.  That’s not necessarily true (see above).  Please don’t ever do anything to risk losing a substantial amount of your account (I consider 1% of your account very substantial).

Once again, I’m not saying that you can’t do this, or that you absolutely never, ever should do this hedging stuff, even though I have only met one profitable “hedge-style” trader in my entire life — and he’s one of the smartest people that I have ever known, and he’s a doctor that works under pressure on a daily basis, and he has had his share of failures in the world of hedging, too.  I count him as a very unique exception to a general rule: traders who hedge generally end up losing a lot of money, anyway.

I didn’t write this week’s newsletter so that I could criticize you personally (although I’m sure that some things that I write can come off that way — sorry).  I wrote it because I’m worried for good traders out there, people who might otherwise have a profitable, happy future in currency trading, but they are led astray by the lure of easy profits or the idea that they will never have to accept a loss.

Rob, I am already in a hedged trade, and I have been riding a loss for a long time.  What should I do?

The good news is this: if you are stuck in a hedged loss, it’s not the end of the world.  You are not necessarily and positively going to lose your entire account.  Here are some ideas for how you can work your way out of the problem:

1. Get a knowledgeable, experienced trader friend to look at your account. Be prepared to tell that person everything about the circumstances that led up to you placing the hedge.

2. Write down on a piece of paper what is that you are trying to accomplish with your hedge, and what some of your plans might be to get out of it.  This might work: “If I exit out of the sell side of my hedge, and it continues to go down, I am going to _____________.”  Or this, “When I exit the sell side of my hedge, I want to see the pair rise up _____ pips, and then if it falls back down through the same price at which I removed the hedge, I am going to ___________________.”  I can’t fill in those blanks for you — but I promise that if you work through the process of making your own plans, you are going to be much happier in the long run, and you will be on the road to taking full responsibility for the situation you’re in.

3. Write down on a piece of paper what you are prepared to lose as part of extracting yourself from the hedge.  Perhaps you will be able to get out of the hedge without a loss, but at least you need to understand what you are prepared to sacrifice if it does not work out.

It’s my goal to help you do things in your trading account that keep you trading for the long term.  Time and time again, as I have worked with traders over the years, I’ve found that traders who are willing to compound moderate gains over time are more successful. 

To me, trading is all about survival, not about the big score.  If you can keep your equity over time, you can learn more and more about what style of trading suits you best.  You can see lots of different market conditions, lots of different market crashes, or how different pairs interact with each other, and much more.

Thank you for taking this journey into trading with us at IBFX.  We are always here to help you — give us a call, or click on a link at left and let us know how you are doing.

Happy trading!