Forex Education and Analysis

Tuesday, 05 May 2009
by John Jagerson

Click here to view video!

In the last article, on the hedging ban from the NFA, we commented that hedging makes it impossible to profit and only winds up feeding your dealer or system seller an extra spread and rollover payment. This was the same rationale the NFA used to issue the new ruling. During the comment period no surveyed dealers were able to provide any evidence that hedging could enhance productivity or produce profits at all. Despite these issues we were surprised to receive very polar responses to the article. Considering this confusion we felt that it would be helpful to break down the issue into more a more detailed case study.

Click here to see the first article in this series on the NFA's new rules about hedging

About half the correspondence and comments sent to us were in favor of the new ruling and felt that it was about time the NFA stepped in to protect novice traders who are confused by the pseudo-benefits of hedging. The other half responded (very energetically) that it was us that were confused and that that hedging was key to creating profits. In the spirit of full disclosure some of the pro-hedging comments came from dealers, EA developers and system sellers. I can only assume that traders suffering from a market version of "Stockholm syndrome" was the source of the other comments.

The rationale presented by the pro-hedgers usually rested on the idea that if you were trading a long term strategy but wanted to scalp or short term trade a completely separate strategy you couldn't do it under the new rules. This is not quite correct. In fact, if you consider the effects of the new rules carefully you will see that the net effect on traders determined to "hedge" is nonexistent. They can continue to accomplish the same things they have been doing it just looks a little different within the account.

Trading with fixed risk but unlimited upside is still possible through fx options, click here to learn more.

This can be shown to be true in a short case study. Imagine that you are long 3 mini-lots of the EUR/USD in a long term trade. If you want to scalp 1 mini-lot of the EUR/USD short at the same time you might run into hedging problems. Because you are already long the EUR/USD adding another long scalp trade is fine under the new rules. The table below walks through the situation of a short scalp trade under the old rules and under the new anti-hedging rules. You will find that the bottom line is the same.

Old Hedging Rules
1. Existing Trade = 3K EUR/USD
2. Enter short scalp 1K EUR/USD
3. EUR/USD falls from 1.3000 to 1.2950
4. Long 3K EUR/USD losses = $-150
Short 1K EUR/USD gains = $50
Net Loss = $-100
Loss plus spread = $-102

Anti - Hedging Rules
1. Existing Trade = 3K EUR/USD
2. Enter short scalp 1K EUR/USD
New Position = Long 2K EUR/USD
3. EUR/USD falls from 1.3000 to 1.2950
4. Long 2K EUR/USD losses = $-100
Net Loss = $-100
Loss plus spread = $-102

If hedgers can still accomplish the same things what are the purposes for the new rules? We contacted the NFA and asked the same question. They responded that essentially they were trying to end the misleading marketing of hedging as a potential source of profits. There are also other issues involved in hedging that present indefensible risks to novice traders. For example, a hedge increases the costs of roll-over and in an illiquid market hedgers are more likely to suffer losses from widening spreads. Although those issues are uncommon or may be small they do exist and since there are no possible offsetting benefits the practice is now banned.

In the video I will walk through a case example of a hedger trading under the old rules and under the new rules. You will be able to see that the bottom line is still the same although the mechanics have changed slightly and the costs have been lowered. You can run through the same numbers yourself in a variety of circumstances and the net results will look identical.

It is very important to understand that there is a lot of misinformation being marketed about hedging. Consider this; if your dealer/system/E.A. provider is lying to you about the value of hedging, what else are they lying about?