ForexSpirit

Up until now I have attempted to steer myself away from incorporating too much hedging into my day to day trading. My trading plan restricts any usage of hedging to dealing with break-outs of the grid to the downside, whereby I use hedging to cover any open positions, as long as my view remains that my one direction will prevail (i.e. that any break-outs are temporary).

Hedging adds complication to position management, and till now I have wanted to keep things simple, so that I can more easily focus on managing the trades I do have open.

After some feedback from my mentor, Dirk, I am beginning to come to realize that maybe now is the time to add a more complex hedging strategy into my trading plan. I am comfortable with my trading methodolgy after following the same trading plan for over eight months. Now might be the right time to review and update the trading plan using the experience I have gained.

There are two main reasons why I feel adapting my trading plan to incorporate a more sophisticated hedging strategy is warranted:

1. Change in the market. There are always going to be changes and shifts in any market traded. Market dynamics will alter as the participants in the market change, and economic situations evolve. The composition of the forex market place has been changing recently, with more hedgefunds and other large trading institutions entering the fray. This has resulted in a change in macro price behaviour somewhat, due to the different objectives these organisations have. The summer range trading on the EUR-USD could be attributed to the larger influence these new participants have, adding strength to the USD when equity market became unhinged in developing nations around the world. The dollar was seen as the default refuge in times of uncertainty. With the coming perceived slowdown in US growth and the affect this might have on slowing world growth, the USD might once again become a safe harbour, in spite of continuing European economic strength. The result of all this is that there will most likely continue to be broad range trading in the months to come. It makes sense, therefore, to take advantage of this situation by using a slight variation on my current trading tactics by placing more emphasis on two-way trading, while still retaining my directional bias. In other words, still trade predominantly in my one direction, while still being open to hedge positions counter to this one direction as market circumstances dictate.

2. Improved loss limitation. I have previously not hedged any open positions that are in the red. I have taken each open trade on its own merits, and closed it only if I felt there was no chance of the market coming back any time soon. Hedging can be used to reduce the effect of any loss, giving the market more time to show its hand. I can therefore lock in a loss at a given level, and if the market continues to move against my original position, I will not lose any more money (beyond the spread cost of the hedge of course). This strategy can be used in circumstances when I am uncertain which way the market is going to move, but I do not wish to risk any more movement to the downside.

An example of this type of hedging might be:
I opened a long position on EUR-USD at 1.27 (my median line) with a gearing of 2:1. Price falls, and at 1.26 I hedge half my open position (i.e. I hedge at 1.26 with a gearing of 1:1). Price falls all the way to the bottom of the grid, and I hedge again, this time at 1.25 again for a gearing of 1:1 (the rest of the original position).

In this way I am managing my risk to the downside. If I end up closing out my original trade plus the two hedge positions that are tied to it, then I have limited my loss to a known amount. If price decides to back up and return to inside the grid, then the skill comes in knowing when to unwind the hedges, so as to not incur any losses from the hedge positions themselves. I am still pondering on how best to tackle this scenario, and my initial thinking is that it seems to be primarily dependent on how much confidence there is in the return to the one direction.

Using hedging more frequently will require a change in my gearing limits, as hedging requires more positions to be open at any one time. My current main broker, FX Solutions, does not require more margin to be used if an open position is hedged, which is useful, but not all brokers provide this advantage, so I will still need to amend my trading plan to factor in the increased gearing that will result. I am only thinking of a slight increase in my gearing limitation, somewhere in the region of a 25-30% increase. That would mean changing my current 9:1 gearing maximum, and changing it to 11:1 or 12:1.