How hedging regulations affect your trading

This month’s NFP release is a good example of how same pair hedging can offset risks in your trading. One of the benefits of the foreign exchange markets is the ability to simultaneously buy and sell a pair netting out gains and losses. Of course, you will see a fixed loss due to spreads and commission charges. I admit I did not understand this logic at first. I did not see the benefits of hedging, but yet I did not understand why the National Futures Association (NFA) placed a ban on hedging in the FOREX market.

Thinking this over for quite a while, I can propose one strategy that takes advantage of hedging. Traders will need to trade differently now, in the United States, at least. Keep in mind this strategy is theoretically speaking and the parameters need heavy adjustments in the real market situations.

To start off with, let’s recap the risk management rule. Pretty much every book, online article, and webinar will talk about the reward to risk ratio. You want this ratio to be as high as possible as who doesn’t prefer high reward to very little risk. For example, a 40 pips take profit and a 20 pips stop loss is much better than a 20 pips take profit with a 20 pips stop loss. Keep in mind that these setups are not predefined. What I mean is that you do not set the take profit and stop loss levels before entering the trade. You set them based on probability. If it takes 20 pips for the price to fail a zone test and to realize the trade is unsuccessful, then 20 pips should be the stop loss. If it takes 45 pips to fail a zone test, then stop loss is 45 pips. Your take profit is estimating where the price can move to. If the projected movement is greater than the loss, then it is a trade worth taking. If stop loss is 50 pips while your projected profit is only 10 pips, that is definitely not a trade to take.

If you take one loss, you need 5 more consecutive winning trades to break even. If you have a 10 pip stop loss and a 50 pip take profit, you can afford to take 4 losses in a row and still come out on top. Anton Kreil mentions institutional traders only profit 40% of the time while retail traders need to profit 60% of the time to beat the market. He broke out the math in one of his videos. Anyways, the point I’m making is that the take profit should not be less than the stop loss.

However, hedging allows you to violate this rule. When you expect the market to be in a whipsaw action such as the NFP release, it is technically possible to violate this risk management rule. Here is this month’s NFP release and we will take it from here.

EURUSD NFP Release
EURUSD NFP Release

I’m in a different time zone so the times won’t align. In essence, you can see the initial sell off before the rapid buying. You have a 50% chance of guessing the right direction or you can avoid leaving this trade to chance at all. If you simultaneously buy and sell, your profits would offset your losses. If you close them out when they bottom out, you reduce the risk quite a bit.

For example, suppose you use a 10 pips take profit with a 20 pips stop loss for a buy and sell trade. If there is no whipsaw action, you would net a 10 pips loss as your take profit would hit on one trade and a stop loss on the other trade. Without hedging, you would have lost 20 pips instead of 10 pips. With hedging, you only face a 10 pips loss. Now assume there is a whipsaw action. Would it not be possible to hit two take profits netting a 20 pips win? If a whipsaw is expected as the market is fundamentally driven, then your new reward to risk ratio is 2:1 making it more favorable. Of course, the ratio is not limited to 2:1, but you can use 3:1 or even 4:1 depending on how your stop loss and take profits are placed.

Keep in mind this is just a theoretical example. The price can still whipsaw even after an extreme move. This example is just to illustrate how hedging offsets risks. It works particularly well in this market as currency pairs represent the relationships between two economies. Yes, there are trending periods. However, it is possible to find a ranging movement on a long enough time frame.

 

Advertisements

A Pip For Your Thought?

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s