Forex Hedging is not a Misnomer
It’s a frustrating delusion when spoken of by a large portion of retail traders who use MT4.
You can certainly hedge in Forex, or with Forex, but what retail traders are often doing is neither. What they are doing is… bizarre, if not terrifyingly ignorant. If you don’t know what the vocal retail Forex trader usually means when they speak of “hedging”, here it is: Having opposing positions open in the same currency pair, at the same time.
It’s what should amount to a non-position — no market exposure. But, through the magic and mystery of MT4 it is indeed possible to have both longs and shorts open on the same currency pair at the same time. Other platforms, and the next iteration of MetaTrader, MT5, take the sane approach and consolidate positions and adjust exposure as positions are opened and closed. Longs and shorts naturally close each other out, as they should (because they do).
The situation is so dire that many find this correction in MT5 to be a complete disaster for their trading schemes. It’s quite literally the end of trading as they know it. The echo-chambers found within forums have fostered a blind allegiance to the “art” of “hedging”, sometimes referred to as “pausing” trades. It’s impressively terrible. Brokers pile-on by also referring to it as hedging, merely because they can and there’s no better and formalized term to refer to this absurd circumstance.
If you apply the same “technique” to any other trading situation it’s clear that a buy and then a sell, or a sell and then a buy, completes the trade and ends the exposure.
Imagine if cars were fungible and you wanted to make a profit by trading cars. Obviously, cars aren’t fungible, but just go along with it for a moment. You buy a car and then sell it for a profit or loss, or sell a car you already own and then buy it back later having made a profit or loss on the whole deal.
Depending on what you consider as having no exposure dictates the starting and ending circumstance, so either you start and end with a car or you start and end without a car, and everything that happens in the middle is the generator of your profit or loss. The moment you take the opposing position you have completed the trade. It should be just that simple.
It wouldn’t matter if you bought the exact same car or not. If you sell Car A expecting car prices to drop so you can re-buy at a lower price and pocket the difference then, with fungible cars, if you buy Car B the exposure is gone and you have completed the trade. You could have bought back Car A, but buying Car B instead provides the exact same result. Now, pocket the difference if prices went down, or suffer the loss of having to pay more than you sold for if prices went up.
If you sold Car A, bought Car B to “pause” or “hedge” the exposure, later sold Car B to “unpause”, and finally re-bought Car A, you have made 2 trades. The purchase of Car B didn’t “pause” or “hedge” anything, it completed the initial trade and you could, and should, have just left things well-alone.
Again, this is if we imagine that cars are fungible, which we know they aren’t. If it helps to imagine something else then do so, but the concept is simple regardless of the analogy.
When dealing with retail trading the situation is a little different, and the analogy doesn’t cleanly work. Retail Forex trading is essentially just a game; A bet. You throw some money at your broker and then you begin playing. If you win they put more coins in your account, and if you lose they take some away. You don’t take physical possession of anything, and retail traders often operate using leverage and margin to take positions larger than their accounts could handle without it.
Now let’s imagine, for unexplainable reasons, we have opposing leveraged positions that in any other reasonable context would have canceled each other out. The value of the long position at any point in time is based on the current bid price, and the value of the short is based on the ask — these are the prices those positions will be closed at, eventually.
So, we have what should be a flat position that somehow isn’t; The opposing positions are based on separate prices that can independently change; We are in leveraged positions subject to margin calls. Does any of this sound like a good idea? It shouldn’t.
If you are leveraged, and the spread widens enough, guess what happens? The long and short both hold floating losses that increase, and where does this eventually lead? That’s right, you can get margin called on one, or both, positions. For trades that should be canceling each other out leaving you flat and unexposed to market movements you are instead subjected to the whims of the spread. A lot of the time this may not be an issue, but it’s a risk nonetheless on a non-position.
And for positions held overnight we are now also subjected to swap payments and costs, which are more-or-less always asymmetrical; Brokers tend to pay less swap than they charge. Now, everything else being equal and the positions surviving for some time, we now regularly lose a small amount of money due to asymmetrical swap.
Let’s briefly recap: Some people hold opposing positions that should cancel each other out but don’t and are capable of triggering margin calls when the spread widens and also end-up costing swap each day.
Why is anyone doing this? None of it makes any sense! The justifications given are convoluted to hide the truth to it all — People who do this don’t know what they are doing, or are purposely making things complicated for themselves for a range of even more convoluted reasons. It’s a deep rabbit hole best avoided.
Just close the position; Don’t mess-around with a technical oversight in your trading platform that only has negative consequences attached to it! It’s not clever or beneficial in any logical or sane way.
It’s not even hedging.
This is just one of the topics covered in my book, Forex Trading for the Savvy Beginner.