Hedging

Sometimes traders, usually inexperienced or going through a period where fear is the prevailing emotion, decide to “hedge.” Using the case of the AUD/USD in my previous posting they might decide to take two trades—one long and one short in the same pair.

Is this a good idea? After all, if you have tight stops and it starts to run in one direction…

The answer is no.

First, this isn’t really hedging which has to do with exploiting inefficiencies across different markets. The kind of trader that would “hedge” this situation usually is one who has a few other walls to climb, e.g. they close out trades too quickly and don’t adhere to tight stops. You can’t make money this way. In fact, you can lose money.

Technical trading requires hard work; technical trading requires making an informed decision.

Gann wrote in How to Make Profits in Commodities, “Many traders have the idea…they can hedge and protect themselves. There is no greater mistake than this. It often turns out the trader loses on both trades. If you are in the market WRONG (Gann used the caps) and don’t know what to do, there is but one thing to do. Get out and wait until you know there is a definite trend….[Hedging] does not pay and you must avoid it.”

Gartley wrote, “The first and most important part of this analytical procedure is the accurate determination of existing supply and demand conditions.” (Profits in the Stock Market) This requires study and hard work. He also wrote, “the technical approach also appeals to many persons because the vast majority are inherently lazy….[but] the technical approach…demands constant study and the application of reasonable judgment.”

Back in July there was brouhaha over the new NFA rules regarding hedging. People wrote posts on forums saying they were going to open accounts with brokers outside the USA because they could no longer hedge. Many of the brokers played into this misunderstanding of the ruling.

FXCM, in its communication to its users on this rule, wrote, “forex traders will no longer have the ability to selectively place stop-loss or limit orders on individual trades, nor will traders be able to modify or close trades from the “Open Positions” window.”

This is not what the rule said. The rule said FIFO—first in; first out.. The first trade you open must be the trade you close first. If you go long and then try to “hedge” by opening a short position, you must close the first long position out before you can open the short position. It has nothing to do with not being able to place stops on any given trade. It has nothing to do with not being able to set profit targets on a given trade. It also doesn’t say you can’t have two trades in the same direction. (Scaling in? Let’s talk about that some other time). Of course you can also have two accounts where you have a long in one and a short in the other in the same pair.

NFA defines hedging as “where customers take long and short positions in the same currency pair in the same account.” The people at NFA think you don’t “understand either the lack of economic benefit or the financial costs involved.” They think you won’t be able to be profitable with this kind of approach. They also think it, “increases the customer’s financial costs in several ways.”

They have a point. When you buy long and sell short on the same pair you pay the spread twice. In addition, while one would think that the interest paid or received on the two opposite positions would offset, this doesn’t seem to be reality in many cases. In part this is because of the squirrely ways some brokers deal with interest.

It’s not my argument that government should be regulating traders to death. Hey, maybe if people want to throw their money away they should be allowed to do so. Regardless of how you feel about that, this rule actually addresses something that gives people the allusion they’re in control. God knows, many of us felt out of control when we first started trading. Some continue to feel that way—buffeted by an irrational market; stops being gunned by the big players; that some system or guru somewhere has the knowledge so desperately needed.

But I digress. The idea of hedging the same pair isn’t for the trader who wants to learn to be successful. To this kind of hedging I paraphrase George Carlin: “It’s BS folks and it’s bad for you.”