Hedging Expert Advisors, The Double Edge Sword

Throughout my whole experience in the area of automated trading I have encountered a fair amount of expert advisors based on hedging as well as correlation strategies. Expert advisors such as the Five Pairs Hedging Expert Advisor have attracted a lot of attention because of the theory behind them. There are also a lot of other forex systems based on this type of strategies, like the Freedom Rocks Program for example, which tries to exploit swap while hedging positions.

First of all, let me explain to you the concept of hedging. To hedge, in finance, refers to the action of taking opposite or complimentary positions on different instruments to reduce risk. Hedging differs from diversification in that hedging implies a correlation between the two instruments while diversification may target completely unrelated things.

As an example, in forex, buying and selling a currency pair at the same time is the most straightforward way of hedging as the profit or loss of any of the two positions is compensated by the other. However, this does not carry any profit for the trader. In a more general fashion, one could hedge different pairs and profit either from the swap differential or from displacements in the overall correlation of the pairs.

The EUR/USD and the USD/CHF have had a historical correlation of almost -0.9, that means that 90% of the time USD/CHF goes up, EUR/USD goes down, and vice versa. If the pairs deviate from this correlation, say, EUR/USD goes significantly up but USD/CHF still does not go down, one could in theory profit from the reestablishment of the correlation by buying USD/CHF.

However, there is a catch. When correlations deviate between pairs, it is fairly difficult to know which pair deviated from the relationship. If EUR/USD went up and USD/CHF did not follow, who is wrong ? Did the EUR/USD pair go up unnecessarily ? or did USD/CHF didn’t go behind it ? This is the question, not always does the first one who deviates is necessarily right.

Hedging is particularly dangerous when it is used as a means of protection, as when one wants to profit from swap. Correlations are a very wavy thing and they may vary and change in the future without ever warning the trader. This is the reason why I advice people not to use the Freedom Rocks system, which seems excessively risky to me and does not offer enough rewards for the excess of capital that is risked. A strategy like this can easily wipe out an account when currencies suddenly deviate a lot from their correlation.

Personally, I don’t like hedging strategies, neither when they are used as protection instruments nor when they are the source of the profit. For me, hedging carries the additional charge of spreads paid for additional positions and does not guarantee the effectiveness of either the profit, or the protection. In my opinion, strong forex strategies that rely on hard stop losses and the use of one open position at a time offer the greatest potential for profit with the smallest possible risk.

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