What is a hedge?
As per Investopedia definition :
"A hedge is an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security."
Read more from Investopedia on hedging here.
Hedging in Markets
There is a saying the best hedge a trader can have is a stop. That's very much true. Trading without stops can be extremely risk and in most cases unless you are a fund, money manager, real cash investor the risk is usually not justifiable. However, hedging can be a valuable tool for every trader with or without the use of stops.
Here we will attempt to explain how hedging can be valuable using the understanding that each market is its own but tends to have correlations with other markets/asset classes.
For example, let us assume SPX and AUDUSD hold a 90% correlation. That means every 1% move in SPX would ideally be 0.9% in AUDUSD.
Do you notice, however, that there a 0.1% difference between SPX and AUDUSD?
Hedge funds, quants and many others try to exploit correlations and these difference. What they would do, is say they like the long side, and they know that SPX is the instrument that moves more than AUDUSD, but don't want full exposure to "risk-on" market moves. They would thus do the following:
Long SPX and Short AUDUSD; Assuming the 90% correlation holds, and assuming a 1% move up the fund will make 0.1% profit from the two positions. Now why would one do that?
The answer is simple, if things go terribly wrong, say the market makes a huge move on a news event, or just any major development that may occur and lead to a large sell-off, instead of suffering 100% losses on the position as the trader normal would have he would only suffer ideally 0.1% of those losses. In essence, hedging can be an amazing way to exploit market conditions and attempt to reduce overall portfolio Beta while increasing your portfolio's Alpha and protect yourself from unexpected market events.
For example, if we take a look at the very volatile week behind us, if a currency trader had a long-risk exposure via AUDUSD but a short-risk exposure via SPX he would have lost about 3% on his Aussie position but gained 11% on his SPX position. Netting a gain of 8%. Last week was a unique situation in which hedging could have been extremely profitable. Generally speaking there is a saying for equities that they take the "stairs" to the upside and the "elevator" to the downside. Thus, usually, during large market crashes FX tends to produce smaller moves than stocks.
Should a trader hedge?
Really that depends on the trader. There are plenty of really smart quant traders that make good profits exploiting complex hedging models. However, for most of us hedging is just a way to reduce exposure. XBTFX manages risks on its liquidity in a similar way to the above described, for example:
We see clients are aggressively buying a certain pair and the risk is unproportiantly higher that what is normal. In these situation if the market is particularly volatile XBTFX may make a decision to hedge some % of the exposure.
In such an instance we look to take, especially if we feel leverage is too high measured by Utilized Margin (Total Margin Used / Account Size), an opposite position to the Net position on our liquidity account.
How to figure correlations?
There are plenty of sites that offer correlations ready on the go on different timeframes, but we advise you do your own. It is actually fairly simple.
1) Select time frame you want
2) Pull raw data from your broker about the two instruments which instruments you want to check
3) Open Excel
4) Select on which price you want to run correlations - Bid, Ask, Mid
5) Open Data Tools in Excel and Run a Regression Model
6) The R squared you get is your correlation between the two, or how much the move of one of the instruments effects the movement of the other instrument.
Can you hedge without correlations?
Actually we believe one can. We believe in a market thats whole dynamic goes around "RISK". Risk stands to abbreviate risk assets or assets that offer return greater than that of what is considered the Zero-Free Rate (US 10y Bond). In FX terms the higher the yield the more risky an asset is. However, rates change and this also changes the correlations and dynamics of markets. Now, these are all the basics a Technician (Person that deals with Technical Analysis trading) needs to know to be able to hedge.
For example, as market dynamics change, you might often see divergences, for example situations in which EURUSD doesn't necessarily go up with the AUDUSD. These divergences occur due to many reasons from big fundamental shifts, to funds buying and so on. In such instances, one should be able to identify them before they actually occur or in the start of their occurrence. That is why, it is usually a good idea for any professional trader to keep a close eye on correlations via their preferred analytical tools and run their own correlation regressions.