As a trader, your success will be solely dependent on the strategy you use. As a result of the increasing volume of daily trades and the number of people and institutions involved in trading, there is equally a high number of trading strategies in the market. I have already discussed the scalping technique in my previous article. Other trading strategies include: hedging, social trading, and automatic trading. In this article, I will focus on hedging as a trading technique and how you can manoeuvre it.
Hedging is one of the most common trading strategy. In addition, it is one of the most challenging strategies in the market today but one which all traders should be aware of. It has made many people such as hedge fund managers wealthy within a short period of time. It is however not an easy strategy.
A good way to look at the hedging strategy is by comparing it with one of the most common financial service in the market: insurance. Whenever you buy insurance, you are simply passing on the risk of any bad thing to a third party. For instance, if you have a motor vehicle accident, the risk will be passed to the insurer who will take care of the repairs.
In the trading environment, when you hedge, you are simply taking an insurance cover against a negative event. As I have explained in my previous articles, in trading, negative events will always be there. At times, even after doing in-depth analysis, the market will go against you. However, when you are hedged, you simply reduce the risk of large losses.
Buying an insurance cover is a simple process. In fact, today with the internet, you can simply buy an insurance cover with a few clicks. As a trading strategy, hedging is a complicated process which entails the use of two securities or assets which have a negative correlation. You hedge an investment by making another investment.
The goal of hedging is not to increase the profits for a trader. In fact, in the financial market, you can never get away from the risk-return tradeoff. Therefore, if you avoid a certain amount of risk, you on the other hand reduce the potential profits you can make. The goal of hedging is to reduce the amount of risk exposure in the market.
Investors and traders using the hedging technique use complicated financial instruments called derivatives which include options and futures. A good example in understanding the hedging technique is considering two companies in the same industry. In this case, lets consider a company such as Airbus and Rolce Royce. Rolse Royce is a key supplier of airplane parts to Airbus. In this case, Airbus will be in deep trouble if Rolce Royce decides to hike its prices on the engines. Using the hedging technique therefore, Airbus can enter into a futures contract which enables it to buy the engines in future at a particular price. This future contract enables Airbus to plan ahead with the real numbers in mind.
With this in mind, it is possible to hedge against all types of assets including interest rates, commodities, currencies, stocks, and indices. To hedge currencies, the goal is to identify 2 or 3 currency pairs that have a positive correlation and then taking opposite directions in the trades. Examples of these currency pairs include: EURUSD and GBPUSD, AUDUSD and GBPUSD, and JPYUSD and NZDUSD among others. To identify the positive correlations between currency pairs, some statistical analysis should be done.
An Example of hedging
I will use the charts below to show an example of how you can use the hedging technique.
In the above charts, it is clear that the AUDUSD pair has been on a strong downward trend of about 2000 pips in that week. On the other hand, the NZDUSD pair was on an uptrend with a higher move than the previous decline. As it can be seen, after the retrace of the weekly and daily chart, the best option was to buy NZDUSD and for safety purposes, take a short position on AUDUSD. In addition, if all the pairs fell, the Australian dollar would be more vulnerable and the NZD would have a relatively small decline. If on the other hand the decision was right, then the NZD would have bigger gains than the losses made on the AUD short.
The goal of being successful is to identify two pairs of assets which have a positive correlation and then making decisions based on it. In addition, it is important to know that in hedging, the total profits you make per trade will be slightly lower than using other strategies such as scalping. The benefit is that hedging will protect you from the risks of losing all your funds.