As much as I try to do my part to squash it, it seems there is always a group of retail forex traders who, for whatever reason, think “hedging” is a good idea. You’ll notice I put the term in quotes there because the way these folks use it varies from the way most people in the markets do. Hedging, in common usage, is the practice of putting on a position in a different market or security which attempts to minimize the risk of a position in some way. For example, someone holding a long position in the stock market could short the S&P 500 index as a way to protect against a general market decline. This is classic hedging.
But not in retail parlance
In retail forex “hedging” has come to mean putting on a position exactly opposite the one you already have. For example, a hedge of this kind could be putting on a 1 lot short in EUR/USD when you have a 1 lot long already in place. The idea most often cited by those who do this kind of thing is that it neutralizes the risk in a position that’s going against them, giving them a chance to wait it out until the market turns. This, of course, is exactly the same thing as just closing the trade.
There are variations on this hedging idea which actually involve putting on both the long and the short at the same time. It’s a kind of straddle play. Sometimes it’s done in what’s call a grid strategy where trades are layered at different levels. The underlying structure of these trades is actually one based on mean reversion or counter-trend action. They look for the market to reverse its recent move.
Using the simultaneous long/short example, the idea is to have a target for each side. The expectation is that the market will move to one target, then turn around and move to the other. That would make both legs profitable. In the meantime, though, going long and short at the same time just locks in a spread loss and one never actually has a directional exposure until one of the legs is closed.
A sample system
An example of a “grid” system I recently heard about (though there are many variations) is from a player who starts with simultaneous long and short positions. He used a 100 pip target. If the market moved to that target the profitable leg of his original pair is closed and another matched long/short pair of trades is put on. This goes on every time the market moves to a 100 pip target level.
Let’s think about what this would look like if the market were to rally 100 pips. First of all, by putting on the original matching long/short the trader has lost the spread because he went long at the offer and short at the bid. When the market rallies those 100 pips the long is +100, but the short is -100, so no net gain or loss. The long is closed, so a realized gain is achieved, but an open loss remains in the remaining open short. Now a new long/short combo is added (again, immediately costing the spread). This means 1 unit of long and 2 units of short, so a 1 unit net short position.
From here, if the market turns down then everything is good because the gain on the 2 shorts will exceed the loss on the 1 long. Should the market keep rallying, though, the loss in the 2 shorts exceed the gain on the 1 long, so the trader is losing money. What you have here is a counter-trend or mean-reversion system, as a result.
Confused traders losing money
All strategies like the one mentioned above can be replicated in a non-hedging fashion. In this case, the trader could have just waited until the market rallied 100 pips and put on a 1 unit short. It would have the same net market exposure and would not have cost the spread twice. That’s the thing a lot of these folks don’t realize. This tells me they don’t fully understand just what they’re doing. They think the risk is lower, but it isn’t.
The reason I wanted to bring this up is because I’ve heard tell of people employing these types of strategies who are followed by social traders. This worries me considerably. This “hedging” is nothing more than a method of accounting (and not allowable in the US, though one can get around it by using multiple accounts). As such, it can create a very distorted view of performance. One could, for example, end up with a high win %, which may be attractive to potential investors, but that hides the major blow up risk underlying the approach being used.
So when you’re looking at traders to follow – either from a social perspective or just from a learning angle – avoid those who employ these types of “hedging” strategies. It demonstrates a lack of understanding of trading mechanics and potentially means they don’t realize the sort of risk they are taking.