Tuesday, September 16, 2014

Why hedging in Forex is important | a practical example

The Financial regulatory authorities in the USA have, for some time now, outlawed what is known as “hedging” in retail Foreign Exchange trading. This involved the taking of an identical size position to an established trade, but in the opposite direction. At first sight it can seem like a somewhat futile exercise as the positions cancel each other out while at the same time attracting the usual transaction costs in terms of spread, commissions and swaps (a swap is the cost of rolling over a position that one wishes to maintain overnight). For completeness is must be stated that while they sound onerous, for serious traders these costs are reasonable.

The reasons for disallowing retail Forex hedging in the USA seem to have to do with the fear that unscrupulous brokers will take advantage of less sophisticated traders in relation to the costs mentioned, and that hedging can, in certain circumstances, reach complex proportions. Apart from the fact that it is the job of the authorities to weed out dodgy traders without imposing restrictions on their clients, the ban smacks of “Big Brother” patronising behaviour.

Here at OmiCronFX we have a good use for hedging (our broker is not in the USA), and it has served us well. To see why, it is first of all necessary to explain why it might be necessary to maintain a position in the face of short-term risk to its profitability. Nobody has done this better than Edwin Lefèvre, in his book “Reminiscences of a Stock Operator”, published in 1923. He relates the story of old Mr. Partridge, otherwise known as “Turkey”, who refuses to sell his holding in a certain stock when advised to do so by the man who gave him the tip for it in the first place. The story makes a play on the word “position”, and the following is an extract:

"I beg your pardon, Mr. Harwood; I didn't say I'd lose my job," cut in old Turkey. "I said I'd lose my position. And when you are as old as I am and you've been through as many booms and panics as I have, you'll know that to lose your position is something nobody can afford; not even John D. Rockefeller. I hope the stock reacts and that you will be able to repurchase your line at a substantial concession, sir. But I myself can only trade in accordance with the experience of many years. I paid a high price for it and I don't feel like throwing away a second tuition fee. But I am as much obliged to you as if I had the money in the bank. It's a bull market, you know." And he strutted away, leaving Elmer dazed.

 What old Mr. Partridge said did not mean much to me until I began to think about my own numerous failures to make as much money as I ought to when I was so right on the general market.

The more I studied the more I realized how wise that old chap was. He had evidently suffered from the same defect in his young days and knew his own human weaknesses. He would not lay himself open to a temptation that experience had taught him was hard to resist and had always proved expensive to him, as it was to me.  I think it was a long step forward in my trading education when I realized at last that when old Mr. Partridge kept on telling the other customers, "Well, you know this is a bull market!" he really meant to tell them that the big money was not in the individual fluctuations but in the main movements that is, not in reading the tape but in sizing up the entire market and its trend”.

A practical example

During the weekend of 5th September last there was a gap down in the GBPUSD pair, after the publication on the Sunday of a poll that suggested that there was a real possibility that Scotland would vote to be independent in their forthcoming referendum (see chart at top).

The following week we wanted to hold on to a long position in this pair, for exactly the reasons outlined in the extract from Lefèvre ‘s book above. However, a similar gap down could be disastrous for profitability because, as the markets are closed over the weekend, our Stop Loss order would be ignored. The solution: put on a hedge of the same size position in the opposite direction. Then, in the event of a gap down, the hedge will capture as profit any amount that was lost from the original position as a result of the gap. The hedge can be removed as and when appropriate.

All associated costs are well within the bounds of what would be regarded as a very affordable insurance policy on the risk involved.

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