In this episode of 2Traders Podcast, Walter and Darren dig into the topic of hedging. You will find out about the tricky aspects of hedging, including hindsight bias and some of the possible solutions for using hedging in your trading.
Also, Walter and Darren talk about brokers and some of the sticky aspects of hedge funds.
Download (Duration: 17:43 / 20.2 MB)
In this episode:
00:47 – a bit tricky
02:05 – hedge my position
03:45 – advantageous
06:19 – trade within the hedge
07:26 – getting dumped
08:51 – expanding hedge
10:49 – break out
11:25 – offshore broker
13:10 – mistakes
14:52 – handy tool
Not being able to hedge can be a disadvantage. [Click To Tweet].
Don’t look at hedging as an additional profit but as a tool for insurance. [Click To Tweet].
Conduct some more analysis, observe, and wait for some good signals to come up. [Click To Tweet].
Darren: It’s important to think about what’s least likely and most likely to happen when you use a hedge. The least likely outcome is for both of them to profit. That’s very rare so you shouldn’t be trying to make it happen.
Announcer: Two traders, Darren and Walter, pull back the curtain on profitable trading systems, consistent money management, and profitable psychological triggers. Welcome to the Two Traders Podcast.
Walter: You’re here at the Two Traders Podcast. I’ve got Darren on the line. Hello there, Darren.
Darren: Hello, Walter.
Walter: Well, last time Darren, we touched on your hedging strategy. I know this is something that a lot of traders used or have considered using and I’ve always found it a bit tricky. I just wanted to get your thoughts and what can you do as a trader?
First of all, why would you use hedging? Why is it even something that you use? Then secondly, if you’re thinking about using hedging, what are some of the things that the pip falls? What are some of the things that traders need to know if they’re getting into this?
Darren: Yeah. I just had an email this weekend from someone who asked me. I emailed him back about hedging. I said that, “not being able to hedge puts you on disadvantage.” He was in the states and his broker wouldn’t allow him to do that. He asked me how are we at disadvantage not being able to hedge?
It was surely difficult for me to answer that question because it’s quite complex in my head. The way I see it is, let’s say we trade trends so we’re a trend trader and we are selling the prime USD. We’ve got a position, it’s in profit and we come to a certain scenario that’s making us think that we should take profit.
But, at the same time, we want to stay in this trend and if we exit it and the price continued, we’d feel really bad about that. So, what I would do is I would hedge my position.
If the price did then reverse completely all the way to your entry level, you’re basically in the same scenario, give or take a few pips that you were originally. Your short position has retraced by a hundred pips but your long position is in hundred pips and it’s in favor.
When people look at it, they’ll say “well, you could’ve two hundred pips there if you have exited and reversed.” That is strongly used in hindsight bias and they’re missing the point which is, at the moment you need to make that decision whether to exit your short trade or manage it. The hedge gives you that certain opportunity of basically hitting the pores button and you’re still protecting your profit as lot end.
But, at the same time, you’re given price sell opportunity where it continues to fall and you got a much bigger win. Obviously, you lose your hedge position and sometimes that will make a difference. There’s a lot to be said for having that ability when you’ve got profit on the table to hit the pores button and just perhaps wait for some old price action.
Perhaps, wait for the next major trading session to start. Perhaps, just for you to be able to make better analysis of what’s going on with a clear head. It’s got a really negative view. That’s like a negative opinion on hedging the same position. How could that be advantageous? That’s looking at it from one dimensional point of view where you could have made more money if you have just stopped and reversed.
Like I said, that’s hindsight bias and that’s being able to predict what the market does. If you can’t do that, which is what I believe, nobody can predict what the market is going to do. Then, hedging is a really good option.
Walter: Yeah, I see this as advanced trading. It’s like a graduate school training. I’m fascinated. I have played around with it. My question is: in that situation, let’s say, you’re in a situation where you’re shorting the GBP. You want to lock in the profit. You’re not sure if it’s going to bounce and go up.
So, you’re going to buy position on how you’re hedged. You’ve locked in that profit on that short. Will you try and trade your way out of the second position, the hedge position? Or will you just dump it and at the same time?
Sounds like, what you’re going to do is you want to at least lock in that profit so at the very least, if the market goes straight up, you will dump both of the positions then, you would’ve locked in that profit. But if it were to go up for a little while and then start to come back down, in other words go in your direction, I suppose eventually you would drop that hedge and just ride out the original position, right?
Darren: Yeah. One of the traps of it is, like you say, trying to trade out of the hedge and get away with both trades being profitable and that is your gut instinct to do that. Generally, If I take a hedge on, I’m looking for price to move out of that range that you’ve defined.
For one of the trades to become a loss and price to continue, hopefully your original short trade becomes much larger, covers the hedge and everything is rosy.
I did, for a while, look for ways of maybe I should move this one to break even now. Maybe I could always get out with two profit trades. That’s tempting to do but it’s not necessary and it over complicates it.
Once a hedge is in place, I’m waiting for the price to move out of that. One of them becomes a loser and the other one to continue on, but something I do is I will trade within that hedge as well.
For instance, if I was short and then I had a buy signal, I’ll take the buy and now I’m hedged. If another short sets up while the hedge is still in place, then I’ll take that trade as well because that hedge has no bearing on that next trade. If I just start trading at that point, it’s a valid set up so I should still take it.
I do trade within the hedge as well, and that happens quite a lot for me. With that kind of lowest swing low, lowest swing high, sort of movement, I’ll quite often end up with two position short when it finally breaks out. That’s the ideal scenario. Obviously, doesn’t always work out that way.
Walter: So, in that scenario, the market starts to go lower, you take a short. Then, it starts to bounce and go up, you take a hedge. Now, you’re hedged and you’ve locked in that initial profit then you get another short signal and you shorted it. Two shorts and one long. My question is: when would you dump the first two position? Which is the hedge, the short and the long? When does that get dumped? When the second signal is dumped as well, is that when they’re all dumped at once or..?
Walter: Do you know what I mean? When the second short is dumped, let’s say, it goes down to a hundred pips. I short it, goes a hundred pips, then I think it’s going to go up and it does go up. It goes up forty pips so I’ve locked in the hundred pips on my hedge.
It goes forty pips then it gives another short signal so I shortened there and then it goes down another two hundred pips, let’s say. I’m up two hundred pips on my second short and I’m up two hundred and sixty pips from my original position but I’m hedged a hundred pips on that, right?
Do you know what I mean? How do you get out of that? I guess I’m fascinated about the execution of the rules of these.
Darren: When I was too short, when the long got stop out and now I’m two position short, then obviously a strong reverse now would be becoming twice as much as risk. I’m obviously down. I’ve managed one of those trades more aggressively, either move into break even.
Generally, what I’ll do is I’ll wait for another long signal to set up. When the next long signal sets up, perhaps, I’ll take the second trade off as profit and then repeat the process again.
You can keep doing that ever, ever expanding hedge. Again, that only works if the market just keeps trending. At some point, it’s all going to come up all the way back to the first trade. At some point, you’ve got to say “that little series of trades played out, it costs me x amount, I’ve got this x amount of profit on the table. Well, I’ll just take the profit off the table.”
That’s your end call to be on the profitable trade. At that point, you can take your profit off. Does that makes sense?
Walter: Yeah, it makes sense. Sounds like one of the traps is, like you say, you want to trade out of that hedge ‘cause it’s insurance, isn’t it? It’s like an insurance premium where you want to make sure you don’t lose that profit that you have on that trade. That’s why you hedge.
You’re going to have to pay that. You don’t want to look at it as another trade or another opportunity to make money. You don’t want to look at that it’s more of just locking in the profit that you’ve already got.
Darren: I think it’s important to think about what’s least likely and most likely to happen when you use a hedge. The least likely outcome is for both of them to profit. That’s very rare. You shouldn’t be trying to make that happen.
The other least likely event is for both of them to stop out. To go all the way back to your first trades, stop it out, then drop all the way back down, then stop out your second trade as well. That’s the least likely.
What’s going to happen nine times out of ten is when you have a hedge like that, price is going to move out of that range and then you’ve got an opportunity to take profit. You just have to wait for price to move.
In the meantime, if a valid trade sets up within that range, by all means take it. Sometimes, I’ll just leave it. I’ll say “okay. Look, I’ve got this hedge set up, price is going nowhere in the middle of it. I’m just going to wait until price moves. When it breaks out, then I’ll assess my position on the profit and the losses and then make my exit decision.”
Walter: That makes sense. For someone who’s listening from a place, a country — we won’t name names — where you are unable to hedge, one suggestion would be just to get another account.
Why not just have one account where you’re taking your trades and another account where you’re potentially hedging those same trades. That’s also a solution right?
Darren: I think that’s a solution or you have to go with an offshore broker. Obviously, there’s downsides to that as well but I think some of them are really good now. I hear people talking about it and some people are quite happy with some offshore brokers as well. Do your research on that.
The only way to go if your broker or if the country you’re trading from where you are won’t allow you to legally hedge the same currency pair then you have to, I suppose, you have two accounts and trade. One is your short and one is long. I don’t want that over complicating the actual process. That’s a little bit annoying.
It’s a really good way of trading and it’s a really good tool to have in your tool box. No matter how you trade, if you trade like of support and resistance or you trade — I mean, how many times have we been in a really good short and where we’re watching: “I know it’s going to support here and that’s where I’m going to exit.”
How many of those that, you know — brilliant I got the exit I wanted, it is bound to reverse here and it continues on and — how many of them which you have been able to lactate on the thirty or forty pip, hedge there and just let things play out a little bit. It’s a really good tool and I don’t think it’s used often enough.
Walter: The main mistakes, the primary issues when applying the tool would be: don’t look at the hedge position as an additional profit. It’s really just insurance. What else would you say is tricky here? Like, what are some of the things that might be mistakes?
Darren: Like you are saying earlier, trying to trade out of them. There is a gut instinct when perhaps we have this hedge, I’m short from twelve hundred and I’m long from eleven hundred, you’ve got to say, “eighty pips locked in there” and sometimes price will just buy out your long trade and then reverse again.
That’s quite hard to take in a way you’ve gone through the process and still now you’re going to end up with even less profit. Quite difficult to follow your system, then. I see a lot of people getting drawdown. The notion that trying to move both to break even when price is in the middle of the range is somehow advantageous. Maybe I find it very hard to believe in all my testing. You much better let the hedge move out of the range and then stop on the trades out.
Just find how it can fit in with how you trade because we’re all trading slightly differently. I’m surprised trend traders don’t use it more. I think it’s excellent, as a trend trader. You’ll never know when the trend is going to end completely. You’ll never know when to close all of your position.
If you’ve got really nice big win, it’s just a great way of saying “I’m just going to put the pores button on here and just see. I’ve got a feeling this trend could go on a bit longer of say, fifty pips when you got a nice big win or whatever.”
It’s just a handy tool to do. Often, when you need to make those decisions, it might be at the end of a long trading day or long trading week. You might not be in the best frame of mind at that moment. You might want to do some more analysis. You might just want to wait for, perhaps, a news release that’s coming up that will be okay. It could really be a good tool for trend traders as well.
Walter: That’s a great point. One of the things that I really like to use as a tool, which is basically what hedging gives you, is this idea that you just wait another candle. Some traders might be in a, let’s say, in some sort of trend trading position where it goes really far and then they’re not sure. It maybe hasn’t forego their trailing exit yet.
It looks like maybe things are going to turn around and go against them but using that hedge, like you say, you can lock in that profit. In practice, you would dump both positions if it were to get back close to your entry price in your original position. Is that basically how you do it?
Darren: Possibly. I will perhaps wait to see if the price continued in that direction. What you’ll find often is, you have a short and then you’re hedging with the long and price will come merely right up to shoulder again, then it will print another second short.
Obviously, what’s happening, those price is ranging but I get that quite often. It’ll go all the way back down to the long and I’ll win two positions there. If you would, you wait back there and say “well, I should’ve just exited the short that I know, then I should’ve gone long and exit there. I should’ve gone short” but it’s very hard to do that. It’s very hard to pick and exit like that and then reverse and go back in the other direction.
Essentially, there’s plenty of lesser variance of what’s going to happen when you take these hedges. You can often have a profitable outcome of also not trying to get the maximum amount of every move and be happy with the decent net profit, then it could be really a good tool.
Walter: Yeah, absolutely. Thanks for sharing, Darren. That’s really interesting. I think that some of the traders out there who are thinking about this definitely gives them a starting place because like you say, it’s so easy with hindsight bias to look back and say, “Oh, you should’ve just done that.”But, you’ll never know when that signal prints out and how far it’s going to go. That’s fascinating.
Darren: Okay, Walter. See you next week.
Walter: See you next time. Thank you, Darren.