Easy hedging strategies

As rumors swirled about a last-minute deal for Greece this week … did investors dare to hope? Obviously not … as the Euro and Dax fell sharply.

There’s only one thing that’s clear about the Greek crisis … that the direction markets will leap on ‘good’ or ‘bad’ news is completely unpredictable.

And leap they will …

So, how do we protect ourselves in these kinds of markets?

With stop losses?

Notoriously unreliable in gapping markets (check out my other post this week on the shocking behaviour of some brokers in gaps).

By keeping out of the markets?

Not a bad solution, but we can do better …

… by ensuring that all your trading is protected with a hedging strategy.

Hedging strategies are not exclusively for big investors and hedge funds – they are something that we can ALL do in our everyday trading.

And it’s not just your trading that you can be hedging – if you have a pension, then you’re already long the stock market … if you own a house, then you’re already long in the land and property market …

Hedging is relevant to us all, so we need to understand how it works (fortunately, it doesn’t have to be complicated) …

How hedging works

Hedging is the financial version of the old fairground metaphor: what you lose on the swings, you gain on the roundabouts.

But the trick is to ensure that you don’t end up with a zero-sum at the end of it.

The first part of hedging is to find your ‘pair’.

The ultimate ‘hedge’ against falling markets has always been gold. Traditionally, when turmoil hit markets, gold prices went up. That way, what you lost on the stock market, you’d hope to make up for on gold prices.

However, in recent years, this pattern has broken down, and the sheer volatility of gold means that it’s just not a practical solution for most ordinary investors (and certainly not for short-term hedging).

Another example would be that if we were invested in a stock, say a retail company that we believed was going to go up in value. Then we’d look for another, weaker company in the same sector, and short that.

So, as our good stock rises, we’re protected from any sudden news that affects the entire sector.

The result is that we have the hedging protection, but we’re still able to profit from our company’s strengths.

Hedging is also used in forex markets.

For example, EURUSD and USDCHF have a strong negative correlation. This means that if EURUSD rises, we expect USDCHF to fall; and vice versa.

So, if we have a long trade on EURUSD, we can protect that with a hedging trade long on USDCHF.

Another way to use hedging is to boost our profits by hedging corrections within a long-term trend …

Hedging strategies that don’t require a ‘pair’ – you’re trading the exact same market in two different directions …

Many investors are put off hedging by the thought of matching up pairs correctly … there’s the worry that, if we get it wrong, we could lose out twice. But hedging doesn’t have to be that complicated – we can even hedge ourselves in the exact same market by trading in both directions.

Let’s say that we have a long position on the USDCAD, which we’re planning on running for several weeks or months …

By looking out for potential retracements on that move, we can take quick short trades, which will enhance the profit on our long-term position. And the best thing about these short-term trades is that they aren’t adding to our risk – they’re reducing it.

A win-win situation.

I often cite Martin Carter’s Diff Code as the perfect example of simplifying hedged trading to its bare bones – and it works.

Buy the stronger thing … sell the weaker thing … profit from the difference … and sleep soundly at night without worrying what Alexis Tsipras will do next.

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