Stops and their Use III – Hedging

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:

  1. A trader initiates a position e.g. let’s say in Figure 1, I go long at .8673 on a breakup above .8666.
  2. As the AUDUSDĀ  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.
  3. At around the previous low at .8581, I cover my shorts for a profit of around 30 pips.
  4. I am now long and exit those at .8679 for a profit of 6 pips.
  5. I make a total 36 pips on the trade.

Sounds good?

Let me postulate another scenario:

  • I go long at .8673 and stop out at .8614 = loss of 59
  • I go long again at .8581 andĀ  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).

blog-2010-06-17-hedging-adus60m.jpg

FIGURE 1 AUDUSD 60-minutes

6 thoughts on “Stops and their Use III – Hedging”

  1. ray, since you do not employ hedging strategy in your trades, i will not defend on it.

    one thing i do agree is that “hedging” using the same instrument on the same contract month is certainly no hedging at all.

    hedging, to my knowledge, is to protect ones exposure. simply put it to reduce the volatility in ones equity account.

    it act as a “cum” on the traders nerves.

    it also provide protection on draw down on equity during market correction, hence to protect ones profit so to speak.

    it provide a foot hold for the trend follower without losing his positions.

    it also provide clearity on the mis pricing of different instrument of hedge that the trader can take advantage of.

    and the list goes on…

  2. Hi Ray, I used to hold a similar view until i looked more closely at the mathematics and risk management of it.The more i heard of companies wanting graduates in maths and programming etc I thought this is another area to investigate. I dont feel i am being dishonest to myself but simply exploring technologies. When i first started,computers, cell phones etc,were just starting to emerge.So i dont think i am being dishonest because the computer generates a moving average or another analysis tool, as an example.My reason for testing it is, to use in high volatility. However i do have utmost respect for your opinions,i wouldnt attempt without some degree of self knowledge of my strengths and weaknesses. I still prefer cold beer to diet coke. lol cheers Baz

  3. I offer another scenario for the same numbers, open both a buy & sell at 8673,cover the short at 8581, open another buy & sell, cover the buy at 8673 or exit all contracts for a profit of 92 pips. You can adjust the range using say an ATR or try standard deviations. My reason for exploring this is based on the premise market is seemingly more volitile now and that the market is said to trend 30% of the time. I thought it may useful during the accumulation and distribution phases of a Tubbs model. cheers Baz

  4. Hi Baz

    We can create any amount of scenarios. For example, I can leave the hedge as is and buy the outrights at the Primary Buy Zone and Sell at the Primary Sell Zone. That would maximize the trade no matter the strategy.

    The point is if you have a buy followed by a sell (and vice versa)in the same instrument, you have a closed out position. This is the one indisputable fact.

    The other more tenuous ground (because it relates only to my experience) is I have yet to see anyone use hedging on a profitable position. So I would ask the question: why employ the strategy only in a loss situation?

    This will be my last word on the subject.

    I am not seeking to change anyone’s mind. If it’s working for you, good luck and do stick to it.

    I am seeking to prevent newbies from adopting a strategy that in my 30-years or so, I have seen no trader using it achieve success over the long term.

    I am not saying it can’t be done; I am saying I have not seen it.

  5. Yes its an indisputable fact but its not what i said to do. I understand your not trying to change anyones mind. I only offer it as food for thought to stimulate some thinking.
    I am evaluating it and so far so good. I just dont want to close my mind to anything and with this frame of mind is why i offered it for comment. cheers baz

  6. its hard not to defend ones beliefs and trading system but so be it.

    i’m on baz side, we all trade our state of mind, our beliefs system. one should always try to explore what is available outside our believes.

    as long as one can achieve cutting losses short and riding winners long (as both are obviously contridicting), it does not really matter what strategy we employed.

    cheers

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