Hedging
Hedging enables a trader to simultaneously hold BUY and SELL positions in the same currency pair at the same time in one account.
There is an ongoing debate between advocates and critics of hedging as to whether it can improve trading performance. Recently this practice has r been drastically curbed by the National Futures Association in the U.S. on retail forex trading platforms offered by Forex Dealer Members.1
While some traders insist hedging is an indispensable tool to help manage positions, its advantages may exist only in their trading psyche while for other traders the advantages in hedging may lie in being able to choose the timing of when profits or losses can be realized.2
Some experienced traders may utilize hedging strategies in this scenario:
A currency pair begins to trend higher due to favorable fundamentals. Trader takes a long position of 10 lots at A. Price advances to B, a long term technical resistance perhaps marked by a previous multi-month or multi-year high. Some long positions in the market liquidate from profit taking and price retreats to C, and this pattern of range trading prevails between B & C, until B finally yields and price advances to D.
Trader recognizes the resistance at B, but he is also convinced of the power of the improving fundamentals. Without relinquishing his original long position, he hedges half by entering a short position of 5 lots at B, with a protective Stop Loss order just above B (>B) and a Limit order at C. As long as the market trades between B & C, Trader can keep his original long position while booking profits on the short term trades. If price goes above B without touching C, Trader covers his hedge at a loss.
Default Setting is “Hedging-Enabled”
Every MF Global FX account has a default setting of “hedging-enabled”. Under this setting, open positions can be closed with a Stop Loss order, a Limit order, or by left-clicking on the [Close] price in the [Open Positions] window. You can also close a trade by left-clicking on the [Ticket] number that you would like to close, then clicking the [Close] button at the top of the FX Trading Station II platform. Please note that a Market or Entry order placed in the opposite direction to an open position will not close the open position, but create a hedged position.
In this example, a short position of 100K in EUR/USD is opened at 1.47277. Five minutes later, a long position of 100K is opened at 1.47260. If hedging is not enabled, the long position would have closed out the short position and realized a gain of $17. Instead it shows both positions remain open with an unrealized loss of $8 which is the spread of $25 minus the unrealized gain of $17.
Costs of Hedging
The cost to hedge an open position is the extra bid-ask spread that you will pay to enter the hedged position. There may also be the additional rollover debit on a hedged position if you are short the higher yielding currency, although generally a hedged position is subject to the usual rollover interest debit or credit applicable to positions held past 5:00 pm EST.
Risks of Hedging
Hedged positions do not necessarily limit risk as traders can find themselves losing on both sides of the trade. Hedging a position may not even lock in the floating profits or losses because dealing spreads may vary when subject to market conditions. For the same reason, hedging does not necessarily prevent a margin call, particularly in a highly leveraged account.
While this strategy tends to work temporarily in ranging markets, it does not work well in trending markets. Stop-loss orders should be placed on open positions to properly mitigate risk.
Margin Requirements of Hedged Positions
An open position can be completely or partially hedged. For a completely hedged position, the Maintenance Margin Requirement is one-half of the total required Maintenance Margin on both the BUY & SELL trades. For a partially hedged position, the Maintenance Margin Requirement is the greater of the margin required on either the BUY or SELL trade. Once account equity falls below Maintenance Margin Requirement and the [MC] status is at “W”, existing open positions in the account cannot be hedged until the [MC] status is reset to “N”.
In the example of the account holding a 100K long and a 100K short position in EUR/USD, the [Accounts] window shows that the positions are margined at ½ of the total requirement.
1 NFA Compliance Rule 2-43(b) Offsetting Transactions. http://www.nfa.futures.org/NFA-faqs/compliance-faqs/compliance-rule-2-43-QA.HTML
2 Please read “Meanwhile…..South of the Border” for an in depth analysis of hedging vs. non-hedging.
