There are some popular so-called "Hedging" strategies being promoted lately and we would like to expose some of the misconceptions so you can avoid possible great losses.
As currency traders we all accept the risk that we will lose money from time to time. Hopefully this does not happen because we simply did not have all the facts or because those who presume to, don't care about our losses.
Grid trading in what ever form it is presented is still no more than placing orders at fixed intervals as the currency pair you are trading moves up and down in price. It is safer according to recent testing to start with a small initial trade.
Rule #1 is that the only true hedge is when you are buying the same amount of lots and selling the same amount of lots on the same currency pair.
The relationship between buying one pair and buying another pair, no matter how tightly correlated they may seem, can change dramatically in a short amount of time.
We start by comparing the GBP/USD and the USD/CHF. It does not matter the ratio of the number of lots we buy of each we can still see the relationship of these two pairs move in and out of phase by watching the "Cross pair".
A Cross pair is found buy removing the shared currency such as the USD of the GBP/USD and the USD/CHF. When we do this we are left with the GBP/CHF. Fortunately we will find this currency pair available on most trading stations and charts.
So even though the GBP/USD and the USD/CHF will go up and down independently and we are only placing trades in one direction (you would do this to collect interest or "Swap"). We are in reality, directional trading the Cross pair. So don't be fooled into thinking you are safely hedged when you are really directional trading the Cross pair (in this case, the GBP/CHF).
So now that you know the truth about correlated pairs you should also know that directional trading can take many years of education and practice before it should be attempted with a live account.
To prove to yourself how this works you can open two DEMO accounts. In account #1 you could buy or go long on 100 mini lots of the GBP/USD and buy or go long on 100 mini lots of the USD/CHF. With out placing any other orders you will see that the overall profit and loss will go up and down dramatically over time. This is a result of the change in correlation. This can work for you or against you depending on when you place your orders. This means the system you may be trading may only be profitable depending on when you open the initial trades. There is no proven method for deciding when to begin trading so if you are wrong you could lose all your money.
You will also notice that over time each pair may travel hundreds of pips individually but it is the overall profit or loss between the pairs that is ultimately important.
In account #2 do the same as in account #1 but, in addition, sell or short 75.36 lots of the Cross pair: GBP/CHF; this account will remain relatively stable in its overall profit and loss.
Because the Cross-Pair is the equivalent of a true hedge, the balance in the account will remain almost unchanged from when you start. Because it costs us the pip spread to enter the trade and this creates a negative balance this balance will remain constant. The difference in the paid or earned interest for holding the lots will change over time but the overall profit and loss will not. Any minor fluctuation you may witness is a product of an imbalance in the updating of the bid and ask prices of your trading station.
A Currency Ring is any group of pairs that equally share the same currencies, such as EUR/USD, USD/CHF, EUR/CHF. Trading these pairs in the following ratios will create a perfect hedge.
Buy 100 lots EUR/USD
Buy 135 lots USD/CHF
Sell 100 lots EUR/CHF
If you are currently have open trades and would like to trade the Cross pair, you can find a calculator below:
Cross Pairs for:
GBP/USD
EUR/USD
USD/CHF
USD/JPY | Are:
GBP/CHF
GBP/JPY
EUR/CHF
EUR/JPY |
Please fill out the WHOLE form. The results will show at the top of this page.
For the curious mathematicians:
The product is 1 and we can confirm by calculating the numbers below.
Prices as of May/21/2007, 04:00 EST
EUR/USD = 1.3506
USD/CHF = 1.2273
EUR/CHF = 1.6578
The total of the ring:
1.3506 (EUR/USD) * 1.2273 (USD/CHF) * (1 / 1.6578) (1 / (EUR/CHF))
= 1
So it's clear the principle is sound.
The statements on this page do not constitute a trading strategy and only serve to
educate you on the truth about the relationship between currency pairs.
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