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How to Hedge Against Risk When Trading

When financial trading, risk is never very far from the market. A calm day can easily turn into a volatile one. Therefore, as a trader, you need to be aware of these risks and know how you can hedge against them. A couple of high profile examples will illustrate this.

First, in January 2016, the Swiss National Bank unpegged the Swiss Franc from the Euro. This was an unexpected move that caused the Swiss Franc to rise and the Euro to fall quickly. In the aftermath, thousands of traders lost money and many trading companies suffered huge losses.

Second, in January 2018, the news broke that China was considering halting the purchases of US Treasuries. This was an impactful event because China is the biggest holder of US debt. When this news was known by the market, stocks had a sharp decline. Other asset classes followed the declines.

So how can you protect yourself against these types of risks when trading? To start, a good strategy to hedge against market risks is arbitrage – also known as pairs trading. In this, you buy a certain financial instruments while simultaneously shorting another asset. This approach takes advantage of the relationships that exist in the market. For example, historically, there has been a relationship between the US dollar and gold. The price of gold tends to rise when the dollar weakens.

To apply the arbitrage strategy, the first step is to find the correlations of different securities at a certain period. There are two methods of doing this. First, you can use free online tools that help you find the correlations between two securities. Another method is to use Microsoft Excel. To do this, you should download the closing data of the two securities, add them in Excel, and then run a correlation formula.

The result will be a number between +1 and -1. If the number is above zero and closer to +1, it means that there is a relationship between the two. If the number is below zero and closer to -1, it means there is no relationship between the two.

For example with crude oil, if you believe that the price will go up, a good method to approach this is to buy Brent Crude, which trades at a premium to WTI. At the same time, you should place a sell trade on WTI. If the price of crude moves up, the Brent trade will be profitable while the WTI trade will be unprofitable as expected. The profit in this case will be the spread - in other words, the difference between the Brent profit and the WTI loss.

However, the arbitrage strategy does not always work. There is a possibility that the two securities will move in the opposite directions from the one you have analyzed. On a larger scale, this happened recently to famed hedge fund manager David Einhorn, who placed a pairs trade by shorting Tesla while buying General Motors. As the Tesla stock increased, the GM trade slumped. At the end of the year, his fund was down by 34%, his worst performance ever.

Therefore, you need conduct a lot of analysis and continue to protect your trades using a stop loss. Lastly, make sure your forex knowledge is always up to date by using the learning tools provided by your forex broker – easyMarkets is a good example of a broker with a comprehensive education section.

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