How do you hedge in the forex market?
June 11, 2008
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John Forman - The Essentials of Trading author
I was asked the following question the other day:
First, about hedging in forex market. How to do that? I read in other forum it is to buy and sell in one pair in spot market. I think that is wrong. Can you explain?
I’ve addressed this issue on a few occassions in a few places. Perhaps it’s worth sharing a quote from someone else on the subject. This is from GammaJammer on the Trade2Win forum in addressing a similar question posted.
There is no such thing, at least not in the way you are most likely talking about. I am guessing you are referring to the practice, described by some retail traders as ‘hedging’ that consists of simultaneously being long and short the same currency pair. In the real world, this is know as being ‘flat’ i.e. having no position. But there is a ton of literature out there that will tell you otherwise. Question is whether or not you choose to believe it. Up to you.
And if you AREN’T in fact talking about this, my next guess as to what precisely YOU mean by hedging would be something like buying usd/chf to hedge a log eur/usd position (as they are fairly highly correlated). This is known as being long eur/chf, and isn’t really a hedge at all (apart from removing some of your USD exposure – not all mind you – watch it move around on payrolls day and you’ll see that for yourself).
An example of what is really meant by a hedge is to buy FTSE puts to hedge a long basket of stocks against a move to the downside. That kind of thing. The two examples of what retail traders get duped into thinking are ‘hedges’ are red herrings because in the case of the first example, all you have done is closed out your position (thus there’s no point in paying double the opportunity / margin costs to have two offsetting positions when you don’t make a bean regardless of where the market goes). And in the case of the second example all you have done is turned a position in one currency pair (eur/usd) to a position in another (eur/chf).
I couldn’t have said it any better myself. I look at forex “hedging” very much as a scam perpetrated on inexperienced forex traders by brokers of questionable ethics. I think most folks who have ever traded and/or dealt with Oanda would say they are among the best, most straightforward and ethical brokers in the market. That being the case, it speaks volumes that they do not permit “hedging” in the same account.
Continuing the earlier questioner’s inquiry:
okie dokie.. but the one i know is, if you buy in the spot market, then sell in the futures. is it true?
Effectively, that’s the same as going long/short in the spot. Spot and futures will converge at expriation and the gain/loss on the futures will be matched by the carry earned/paid on the spot (and of course the directional movement will even out). It’s basically a wash. Actually, given spreads and transaction costs, it more likely a losing proposition.
Knowing more on the hedging techniques and learning on the subject more.
Regards
[...] have long made my feelings about this so-called “hedging” known (see How do you hedge in the forex market?). It probably goes without saying that I am quite happy to see this rule put in place because I [...]
mmm, couldn’t you open two accounts, then open one long in one account and one short at the same time in the other account. That way you are covered which ever way the market goes. Bet high and get in and out of the market targeting 10 pips a day during the London open, turn off computer and go and play golf. Dunno, maybe I’m being naive but it is a nice dream.
Pete – You can indeed use two accounts, though you need to make sure there’s sufficient margin funding and the ability to quickly move funds between accounts to make sure one side doesn’t get margin called.