6 May 2010 was a normal day for the markets. In the UK, residents were going to an election while in Wall Street, the only concern among traders was the Greek debt crisis. Then, in the afternoon, something unusual happened. All of a sudden and without any major news headline, US markets tanked with the Dow shedding more than 1,000 points. This event is now known as the flash crash.
A similar decline in the world’s markets happened in January 2015 when the Swiss National Bank (SNB) unpegged the franc from the dollar. It was a surprising move because no one expected it.
Those unexpected events are not common but when they happen, traders and investors lose billions of dollars. Unlike other major events such as Brexit and global elections, no one can predict when these events will happen. This brings the need for proper risk management strategies in anticipation for such happenings.
A good way to minimise the risk is through hedging. Hedging is the practice of minimising risks by opening multiple trades and benefiting from the spread between the profit and loss. Here are some of the best hedging strategies you can use.
Opening two trades of the same security
Opening two trades of the same symbol is a safe way of hedging the risks in the market. For example, assume that the EUR/USD pair is trading at 1.1200. After doing your analysis, you find that the pair could gain 10 pips and reach the 1.1210. So, you decide to buy one lot of the pair, with the take profit at 1.1210 level. To reduce the risks, you can decide to sell half a lot of the pair. If the trade goes right, your bigger buy trade will be profitable, but the smaller sell trade will make a loss. In this case, your profit will be the spread between the profit and loss of the trade. On the other hand, if the pair goes down, your bigger trade will make a loss, which will be offset by the profit on the smaller trade.
Trading the safe havens
A few currencies and securities are regarded as safe havens. The assumption is that traders tend to move to them when risks increase. The Japanese Yen is regarded as a haven because of the massive external treasuries the Bank of Japan (BOJ) holds overseas. It is the second largest holder of US treasuries after China. For this reason, the yen always gains even when North Korea fires missiles above Japan.
The Swiss franc is also regarded as a haven partly because of the stability of the Swiss economy and the strength of the Swiss financial system. A study by a group of economists from Bundesbank for the period between 1986 and 2012 found that the Swiss franc tended to appreciate during periods of increased volatility.
Another way to hedge against risk is to apply the concept of correlations. This concept emerges because of the various relationships that exist between different assets. Closely correlated assets move in the same direction while inversely correlated assets usually move in the opposite direction.
A good example of historically inversely-correlated securities is between the US dollar and gold. Gold is a metal used mostly for investment purposes and is always quoted in dollar terms. Therefore, when the dollar rises, gold tends to fall and when the dollar falls, gold tends to rise. Between January 2018 and mid-August of 2018, the dollar index had gained by more than 5% while gold had fallen by more than 4%.
Near-perfect correlations happen in other securities too. For example, because of the close relations in crude oil supply, the price of Brent – the global benchmark – and West Texas Intermediate (WTI) move in a similar direction. In the period above, Brent and WTI had gained by about 7%.
Currency imbalances create good hedging opportunities for traders. In the case of crude oil, a bullish trader can buy the expensive Brent futures while selling the relatively cheaper WTI crude. If the price of oil moves higher, the Brent trade will be profitable while the WTI trade will move lower. The profit will therefore be the profit of the Brent minus the loss of the WTI.
The same strategy can be used in inversely-correlated pairs like gold and the dollar. A trader bullish on the dollar can hedge the trade by selling short gold futures.
An easy way of finding correlations between securities is to fill their closing prices in Microsoft Excel and then to execute a correlation function.
Arbitrage is a form of correlations trading where traders benefit from the related movements of securities. There are several types of arbitrage opportunities used by traders to hedge against risk.
Merger arbitrage is used by stocks or CFDs traders to benefit from mergers and acquisition (M&A). When an acquisition deal is announced, the stock of the two companies move in different ways. The stock of the company being acquired moves up while that of the acquiring company moves higher. Therefore, a trader can buy the stock or CFD of the company being acquired while simultaneously selling that of the acquiring company.
In statistical arbitrage, a trader creates two ‘baskets’ of securities. The first basket has currency pairs that are oversold while the second one has overbought pairs. The trader then buys the pairs in the first basket and then simultaneously sells the pairs in the second basket. The hope is that the two baskets will reverse and generate a profit for the trader.
In risk arbitrage, a trader considers two or more markets. The most common method is to consider the emerging markets and the developed markets. A trader who is bullish on a developed market currency like the dollar can simultaneously short currencies from the emerging markets. This is because a stronger dollar tends to affect commodities like platinum and gold that are found in emerging markets like South Africa.
In triangle arbitrage, a trader exploits the opportunities that result from a pricing discrepancy among three currencies. With this, a trader exchanges the first currency with the second, the second for a third, and the third for the initial. The three common pairs used in this form of arbitrage are the EUR/GBP, GBP/USD, and the EUR/USD. Remember that while it is essential to know about arbitrage, it is not permitted to trade arbitrage here at OctaFX, you can learn more about this prohibition here.
Hedging is a good way to limit losses in the financial market. This is because a trader who opens one un-hedged trade is always exposed to the downside risks. Still, hedging requires a lot of practice to perfect. A demo account from OctaFX can help you improve your hedging skills.