BarroMetrics Views: Stops and their Use III – Hedging
Today I’ll conclude this series.
Let me first say that this is my view and I don’t expect to change anyone’s mind. Let me also say that I believe ‘hedging’ to be one of the worst practices novices can adopt.
Let’s be clear about what I mean by ‘hedging’: I mean taking opposite positions in the same instrument. If trading futures, it usually is in the same month but I have known traders who ‘hedge’ in different months. In the latter case, it is the trader’s intention that distinguishes ‘hedging’ from ‘arbitrage’.
In this blog, I’ll make it simple and talk about ‘hedging’ in the same month. The same principles would apply for those trading FX and I’ll use AUDUSD 60-minute chart as an example.
The practice is simple to illustrate:
- A trader initiates a position e.g. let’s say in Figure 1, I go long at .8673 on a breakup above .8666.
- As the AUDUSD declines below 50% of the range, rather than stopping out, I go short .8614. In other words, I keep the long and short of the same instrument as two separate trades.
- At around the previous low at .8581, I cover my shorts for a profit of around 30 pips.
- I am now long and exit those at .8679 for a profit of 6 pips.
- I make a total 36 pips on the trade.
Let me postulate another scenario:
- I go long at .8673 and stop out at .8614 = loss of 59
- I go long again at .8581 and exit at .8679 = Profit of .98
- Net profit = 39 pips.
Note that I used exactly the same numbers in both examples.
In short there is little difference in the Profit and Loss numbers if you take two trades rather than hedge. So, why do so many traders swear by it?
I don’t know – perhaps it’s a way of avoiding the ‘pain’ of a loss; perhaps it’s a way assuaging the fear of missing out. What I do know is it makes no sense, at least to me.
- Firstly, a ‘buy’ and ‘sell’ in the same instrument is one round turn i.e a trade that is closed out. The fact that the trader separates the two does not make it less so.
- Secondly, the trader is faced with an ‘open’ loss the moment he lifts, one leg. That loss will turn into a profit as long as the sideways trading range continues. If there is a breakout, the trader will be faced with dealing with the open loss.
- Finally, in my view, ‘hedging’ encourages dishonesty with ourselves. It’s easy to slip into the idea that there is no loss because we are ‘hedged’; the reality is there is a loss – the difference between the long and the short. (I have never known anyone to ‘hedge’ a profit).
Hedging in FX is now illegal in the USA.
It seems to me that rather than ‘hedge, we’d become better traders by becoming more self-aware (why am I ‘hedging’ since there is no logical reason for the practice) and become better acquainted with the stages of a market (understanding the high probability trading zones of a sideways market).
FIGURE 1 AUDUSD 60-minutes