Money management is the #1 reason retail traders tend to lose money over time. In fact, studies of millions of trades made by thousands of accounts have shown that traders tend to maintain win/loss ratios of about 50/50 but their profits are far outweighed by their losses to the tune of some 70% (pips lost average around 83 while pips gained average around 38).
With that in mind, I want to discuss the tactic of hedging your trades. Hedging is basically insurance. Like you insure your car against losses or how you might buy insurance at the blackjack table in case you pull a losing hand. It covers your downside against full or partial loss.
There are two techniques I will illustrate. I have used both very effectively myself and both are pretty straightforward techniques with the 2nd tactic being a bit more complicated. Let’s begin.
Straight Hedge
This is a very basic hedge against loss where you would simply enter your trade, long or short, and simultaneously enter another trade in the opposite direction of the first. This is borrowed from what is called a Straddle in options trading but is a bit different given the nature of the two but the concept is the same. You can use this tactic when you’re unsure of which way the pair price will go. Here’s an example:
EURUSD is trading at 1.07000. A news announcement is coming but you don’t know how markets will react. You can enter a $1 lot long and $1 lot short at the same price of 1.07000. Once the news is announced, let’s say the price jumps 100 pips to 1.07100. You would effectively zero out because this is a neutral tactic. But in this case, if it became clear to you that the news was good, you would simply close out your short at some smaller loss and let your long profit ride up. For instance, at 1.07050 you close the short for a 50pip loss but gain the remaining 50 to 1.07100 netting a 50pip gain, less fees. If the price drops on the news, you simply reverse the process.
There are several variations you might employ with the straight hedge. You could hedge 1 to 1, like the example above. Or you might hedge 2 to 1, in which case you enter long $1 and short $0.50. In which case a price pop of 100 pips upward means your long is a $100 gain and your short is $50 loss, netting you $50. Or you might increase the leverage to 3 to 1, etc., thereby creating a partial hedge. This can also work out well to stave off any temporary moves against your position between overall entry and exit of the pair – you don’t apply the hedge simultaneously with the entry but instead apply it later on when you suspect a move against may be occurring intermittently.
The next tactic involves a bit of dollar-cost averaging combined with hedging but not hedging in the traditional sense. This tactic creates an effective hedged position.
Dollar-Cost Hedge
Dollar-cost averaging, or DCA, is when you employ multiple entries into a security (otherwise known as “scaling in”). For instance, you believe the EURUSD pair is beginning a trend upward from 1.07000. You might buy it every 100 pips, effectively creating an average price paid (1.07000, 1.07100, 1.07200, 1.07300 averages to 1.07130). It mitigates risk of the trend failing and keeps you from losing money like you would have had you jumped in at 1.07000, all in.
Now, here’s where it gets complicated mathematically.
You will need to use Limits (as you should anyway for enhanced money management). The question is where do you place those limits? You place the limit on your subsequent entry according to the breakeven or profitable price of your previous entry. Tricky, no? Ok, so the best way to illustrate is by example:
Using EURUSD again, we expect the current price of 1.07000 to rise. We’ll use $1 lots. 1st entry is 1.07000 and the price appreciates 20pips to 1.07020 and you’re up $20. Put a limit at 1.07000 so you breakeven in the event the price retraces. The price continues upward and we enter a 2nd position at 1.07040 and raise the limit on the 1st position to 1.07020, guaranteeing at least a $20 profit on it.
This is now an effective hedge for the 2nd position where we can break even if the 2nd position retraces on us down to 1.07020, thereby losing 20pips ($20). The 1st position is limited to 1.07020 and will close out for a 20pip gain, while you (or your 2nd position limit) close the 2nd position at a loss of 20pips, thus zeroing out both positions.
That is a scenario for a basic, 2-position DC hedge. But as you can probably imagine, you can build upon that and essentially create a laddered overall position where you can theoretically have as many positions as you want that would have overlapping and offsetting limits that eliminate all or most of your risk of loss. Imagine a 5 or 10 position ladder with absolutely no risk of loss because they’re all offset to each other to break even.
Yet (and this is the real beauty of this tactic) the tactic also assumes a general direction of the price and so you’ll still be making profit on each subsequent position entered as long as the price goes that way. Thus, should the price go the way you think, you will have several positions in profit that you can close when you hit your price target. This tactic is very powerful, as you can see, although a bit complicated to set up. But once it is, you can pretty much sit back and let it run risk free.
So there you have it. Two powerful, risk eliminating hedge techniques you can employ in your forex trading that will have you better managing your money and get you to those satisfying profits we chase every day.
Happy Trading!
*Note: Try varying leverage, timing, limits and breakevens to perhaps enhance these techniques, once you get comfortable with the basic forms.
