In yesterday’s No More “Hedging” for Forex Traders post I pointed out a new rule from the NFA going into effect on May 15th which effectively eliminates “hedging” as it has come to be known in the forex market. That’s holding simultaneous long and short positions. In every other financial market doing that is an offset, meaning the trader has no position. The NFA ruling thus brings forex in line with markets like futures. (It should be noted that having opposing positions in different accounts is restricted, so technically folks can still “hedge” if they so choose.)

Predictably, given the feelings that have generally been demonstrated on the subject over the years, there was a pretty intense response. Some of them are on my side – the one which says that hedging does not provide a net benefit to the trader, but does make the brokers more money. Some of them were of the opposing view. One person left a lengthy comment in defense of “hedging” which I wanted to take the time to address separately since it very much outlines the view of many of those who employ these strategies hold.

Here it is. My comments are below.

I am a Forex Trader/Investor. I have 3 Live Accounts with 3 different Forex Brokers. I trade Full Time for a Living. Forex Trading is Our Only Income. I was extremely shocked to hear all the buzz in the Forex Community that you guys were trying to Ban Hedging. Then, I saw in one of your e-mails about it and almost passed out. I started to wonder, whose side are you guys on?

If you Ban Hedging, you would essentially be giving the Forex Brokers/Market Makers a License to Steal from Us the Consumer. Here are the reasons you should Never Ever, Ever Ban Hedging, if, your purpose is to Protect the Consumer/Trader/Investor.

The Forex Market is extremely volatile. When Trading, you Always have to Protect Your Account Balance either, with a Stop Loss (which the Brokers and the Market Love) or a Hedge Position (which the Brokers and the Market Hate) if the market turns against you. If you Do Not use one of the 2 above mentioned Protections, you could Lose, and probably will Lose, your Entire Account Balance, and be out of business.

When you use a Stop Loss the Brokers know exactly where all the Stop Loss Orders are, and often, the price will magically reverse and go up through price areas where people would put, and do put stop losses. (This is called a stop run. This is done intentionally by the Brokers/Market makers) I have seen this happen daily for almost 4 years now.

For 3 years I have taken a beating in the Forex Market due to being Stopped Out and taking loses. My loses STOPPED when I learned about Hedging!!! Up until recently, the Brokers had a field day with my Stop Losses. Now that I know about Hedging, all 3 of my Trading Accounts have grown instead of shrunk.

Just yesterday I had a situation where I sold the EUR/JPY and it mysteriously started going the wrong way. I double checked all my reasoning for selling the pair and couldn’t figure out why it was going up. (This happens in the Forex, sometimes Mysterious, and Magical Moves Happen with No Explanation)

After I was down over $2,000.00 per account (over $6,000.00 total) I bought the pair with the same amount of lots, Stopping My Loss without having to Close My Losing Position and Taking a Real Loss of over $6,000.00. (Or, in other words, I put on a Hedge) (If there was no Hedging, I would have had to use a Stop Loss and incur the Loss of over $6,000.00)

After putting on my Hedge, I went to sleep, this was at about 4 am est. The next day I looked at the charts around 1 pm or so. I saw that the EUR/JPY had moved up substantially while I slept. (Boy was I glad I put the Hedge on when I did!!) Anyway, the Pair was showing clear signs that its move up was over, and that it was going to go down now. I closed out my Hedge and banked over $7,500.00 per Account or ($22,500.00 Total) Now I only had to wait for the price to move down to where my negative on my initial trade was at minus -$7,500.00 or less and close it out, thus giving me a break even or a profit depending a what price I was able to close out the losing end at.

I ended up closing out my losses at minus -$6,000.00 thus making $1,500.00 per Account or ($4,500.00 Total) because I was able to Hedge, If not, I would have lost over $2,000.00 per Account or (over $6,000.00 total)

This is not an isolated incident. Because of being able to Hedge, I am now a profitable Forex Trader able to beat the Brokers/Market Makers at their own game.

PLEASE DO NOT TAKE AWAY HEDGING AND GIVE BROKERS A LICENCE TO STEAL!!!!!

HEDGING PROTECTS THE CONSUMER FROM THE BROKER AND THE MARKET ITSELF!!!!!!!”

Brokers Hate Hedging
First, let me address the idea that brokers love stops and hate “hedges”. This is complete and utter crap. Think about it. “Hedging” means more trades. Brokers make their money on the spread and/or on commissions. The more trades that get made, the more spread or commission they make. This applies to ALL forex brokers – the dealers and the ECNs alike.

The brokers running stops argument is mainly that the brokers are trading against you. First of all, ECN brokers do not take any positions. They are like stock or futures brokers with no influence at all on prices. So if you have any concern at all about your broker being on the other side of your trade, switch to an ECN.

As for the dealing brokers, realize that the vast majority of positions held by customers are offset by those held by other customers and/or hedged in the market, so the brokers are generally not in an exposed position to price movements. I’m not saying they are never net long or short, but my point is that they stand to make plenty of money in a zero-risk position by simply buying at the bid and selling at the offer like any market maker in any market.

Also keep in mind that stop orders are both entry and exit orders and they can be used to both exit losing trades and to lock in profits. In other words, just because there are stops it doesn’t mean that if they are triggered the broker makes money.

I will not be so foolish as to suggest that market makers – be they brokers, bank dealing desks, hedge funds, or whoever – don’t look to run stops. It happens, just like it happens in exchanged traded securities, and has done for probably as long as there’s been the ability to leave an order in the market. The regulators do their best to prevent fraud, but it doesn’t take fraud to figure out where a lot of orders may be sitting and take advantage of it when the opportunity arises.

To specifically address this person’s gripe about their stops getting hit all the time, my feeling is that they are probably putting them much too close to their entry points. Regular readers know I’ve addressed that particular subject many times.

Looking at the Scenario
Now let me address the scenario brought up above. I’m going to express it in terms of a trading full lots of EUR/USD to put it in terms that will be perhaps a bit easier to understand because of the easy pip-to-dollar conversions – a 1 pip move in EUR/USD for a full lot position being worth $10. So let me lay it out.

1) Trader goes short 5 lots (I don’t know if that’s right, but follow me with the numbers).

2) Market rallies 40 pips, putting the account $2000 in the negative ($10 x 5 lots x -40 pips)

3) Trader “hedges” by going long 5 lots.

4) Market rallies 150 pips. Long position is up $7500 ($10 x 5 lots x 150 pips), but short is down $9500 ($10 x 5 lots x -190 pips), so the trader is still -$2000 net.

5) Trader exits long

6) Market drops 70 pips. Short position is now down $6000 ($10 x 5 lots x -120 pips).

7) Trader exits short. Final profit is $1500.

This all might sound well and good, but now I’ll show you why this trader is no better off than someone who exited the short position at 40 pips down, then sold again at 190 pips up. I’ll use prices and do a side-by-side comparison.

Hedging Stop and Re-enter
1) Short 5 contracts at 1.3000    Short 5 contracts at 1.3000
(selling in both cases at the bid)

2) Long 5 contracts at 1.3040     Exit short at 1.3040
(buying both at the offer)

Net P/L -$2000                                Net P/L -$2000

3) Exit Long at 1.3190                     Short 5 contracts at 1.3190
(both executed at the bid)

Net P/L -$2000                               Net P/L -$2000

4) Exit Short at 1.3120                    Exit Short at 1.3120

Net P/L +$1500                              Net P/L +$1500

As you can see, the two approaches achieve exactly the same result. The putting on of the long position when the short is 40 pips under water locks in a $2000 pip loss just as surely as if the trader exited the short then.

Wait, I need to correct myself there. The results aren’t exactly the same.

It sounds like the hedge approach actually involves an overnight carry (per the outlined scenario), while the strategy which stops the trader out does not. That means the hedger is paying the net interest differential, so actually he is going to end up making slightly less – in this scenario.

But Really, It’s Much Worse
Generally speaking, one goes long because they expect the market to rise. The trader in the scenario above clearly thought at the point where the market was 40 pips against his position that the odds favored it continuing in that direction, otherwise he would just stay net short. That being the case, a long position makes sense from there. If the trader had taken the -$2000 hit on the initial short, he could have made $7500 going net long. Instead of being still -$2000 in net when taking off the long hedge, he would have been +$5500.

And of course there’s the lingering question of what would have happened had the market kept moving higher after the trader took off the long position? The losses would have just kept piling up is the answer, of course. Or what would have happened if the market actually did turn around and go in favor of the initial short trade after the long hedge was put on? The trader would have forsaken that opportunity by being net neutral.

Hedging Doesn’t Solve the Problem
My experience in talking with traders about hedging as a stop is that it’s being done by traders who simply use it as a way to avoid taking a loss and being wrong, with all the psychological ramifications therein. It doesn’t promote the development of good trading. In fact it hampers it by blurring what’s really going on so the trader doesn’t get a realistic view of what’s happening with his trading.

From the way the note was written, it sounds like the trader looks at the whole set of positions as a winning trade when in reality it’s basically a couple of different trades. It doesn’t force the trader to look at that initial short as the loss that it was, which viewed properly would then encourage the trader to contemplate why it was a losing trade.

Further more, the hedging action doesn’t provide the clean slate which being completely out of the market does. Part of what exiting a position does for you is allow you to take an fresh look without the bias having a position creates. In the scenario above it could have allowed the trader to see the opportunity for a long trade which would have made very nice gains.

As always, thoughts and opinions are welcome and encouraged.