Some people wonder whether or not they should hedge. They hear all this talk about diversification, about hedging to reduce risk. It is true that if you are in a profitable trade, and you hedge, assuming it is a smart hedge, then you will reduce risk. But you also reduce the reward as well. You can accomplish the same thing of reducing risk and reducing reward by just taking some profits on your existing position.
Some people see the words diversification and hedging and believe that if they do it enough, or open up enough positions that they can magically diversify away risk. You may or may not diversify the risk. You will certainly reduce the rewards and money that can be made. In the worst of cases you will reduce the returns, while still suffering big losses since even many positions spread across many different markets can still have correlation among them and an implicit global macro bet within them.
Should You Hedge?
For example, lets say you are long eur/usd and it is losing you money, should you hedge by shorting gbp/usd or shorting aud/usd?
My answer to that would be no, do not hedge by shorting another currency pair. It will most likely not be a perfect hedge. Reasons? Global macro, each country economies and business cycles are different. Perfect hedges are very difficult to find.
For example if you are long EUR/USD and short AUD/USD. If there are eurozone specific bearish problems that emerge that can cause EUR/USD to fall faster and more than what your short position in AUD/USD would fall. The reason being that the eurozone specific order flow generators caused the market to move by a lot in addition to any risk aversion in the market. The risk aversion can cause AUD/USD to fall as well, but if their economy is still performing well and they will not reduce rates, then that will help to prop the market up a bit. AUD/USD can still fall, even a lot, but if the eurozone specific problems emerge then that will cause EUR/USD to fall even more since there was a specific order flow generator and scenario to the EUR/USD position.
Remember that establishing a position in a currency pair is a macro bet on two scenarios for two different countries/economies. So when you are going long EUR/USD, you are not just betting on USD weakness, you are also betting on some form of EUR strength or out performance relative to other currencies.
Similarly when you are shorting AUD/USD, not only are you betting on USD strength and risk aversion to cause a safe haven dollar bid, you are also betting on the AUD economy to under perform or suffer more than other economies.
There can be days when all the currency pairs fall or rise by pretty much the same amount, but eventually there will come a time when their rises and falls will start to diverge from each other due to other order flow generators being activated by the other currency in the pair. It could be a few hours later, one day later, a few days later, or a few weeks later.
For example if you see EUR/USD, GBP/USD, AUD/USD, NZD/USD all moving higher by 100 pips during one day, that can be attributed to specific dollar weakness. But eventually they are each going to do their unique movement. Sometimes that unique movement can be to rise 30 pips more than the other currency pairs. Other times that can be to rise 30 pips less than other currency pairs. In extreme situations you can have a scenario where one currency pair for example EUR/USD rises by 100 pips while GBP/USD drops by 100 pips. That tells you that something is occurring between the two countries to cause such a drastic shift in the correlations. Sometimes it can be temporary, other times more longer lasting.
Instead of Hedging, Trim Your Existing Position
Which is why perfect hedges are difficult to fine. Even good hedges are difficult to find.
Also, by hedging you are attempting to run around the problem of a losing position instead of confronting it head on as you should.
Throwing on a hedge can multiply your problems, especially if it is a bad hedge. If you are long EUR/USD and it is bleeding money, and you hedge by shorting AUD/USD, then a few days later you find out that EUR/USD has dropped 400 pips, but AUD/USD is only down 200 pips, then you have two problems instead of one. You have two positions to effectively manage instead of one. You have compounded the problems instead of addressing them.
If a position is bleeding you money and you are contemplating throwing on a hedge, the better decision, in most cases, is to reduce the size of the existing position or to liquidate it.
The perfect hedge, so to speak, is to liquidate or trim your existing position!
If your current trading position is in a loss and you are suffering so much pain that you are contemplating throwing on a hedge, the market can be telling you something! It could be telling you that you should have bailed out already. Or that you are trading with too big of a position size concentrated in that one position. Or that the trade is turning sour and you should bail out.
Instead of worrying about hedging, I like to spend my time and efforts catching the next big move.
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