Is this hedging?

[Lyubomir]

As far as I know if you buy one currency pair and sell the same
currency pair simultaneously you're doing a full hedge. But let's say
you do this:

Buy 1 lot GBPCHF
Buy 1 lot EURGBP
Sell 1 lot EURCHF

Is this a full hedge?

If you hold the three positions for a very long time what is going to
happen? Minor fluctuations? How much fluctuation in pips is possible?

Do you need to calculate your position sizes beforehand, instead of
just ordering 1 lot of each, and how?

Or am I totally on the wrong track?

Your observations and opinions on the topic are highly appreciated.

[Nonpiker]

You would be left with a small position in gbp/chf since you would only sell roughly 69% of your sterling from that position when you bought eur/gbp. That is of course based on the current rates. You then dump your euros when you sell eur/chf. In addition, you are left with chf since you are getting 1.4 the amount of chf in gbp/chf as compared to eur/chf.

If you hold those for a long period of time with a retail broker you will lose money from crossing the spreads on the rolls. Putting those position on all at one time is rather pointless from what I can tell. All you are doing is giving your broker free money by crossing 3 spreads.

[Jeditrader]

Originally Posted by Nonpiker

If you hold those for a long period of time with a retail broker you will lose money from crossing the spreads on the rolls. Putting those position on all at one time is rather pointless from what I can tell. All you are doing is giving your broker free money by crossing 3 spreads.

I would only add that you will pay or receive roll charges with any forex dealer such as a bank, not just "retail" dealers, or brokers. Those charges are a fact of life with institutional deals or retail deals all the same, however some retail firms charge more for rolls, especially on mini accounts.

Also many novice retail traders attempt such "hedge" trades for no apparant reason or apparantly because they think the trades allow some kind of low risk ability to somehow participate in the market. The effect is that there is probably a very limited profit potential and, as stated above, only the opportunity to pay fees for entering/exiting the market and fees for carrying charges. As always the best course is to have a well thought out plan and only venture into the market with a position that has all of your bases covered such as a clear profit potential and risk management strategy.

[CTC]

Use the following for Currency Correlations:

Visit our Currency Training Center for more useful information and our "Live Trading Room"

Currency Correlations

To be an effective trader, understanding your overall portfolio's sensitivity to market volatility is important. But this is particularly so when trading forex. Because currencies are priced in pairs, no single pair trades completely independently of the others. Once you know about these correlations and how they change, you can take advantage of them to control over your portfolio's exposure.



Defining Correlation
The reason for the interdependence of currency pairs is easy to see: if you were trading the British pound against the Japanese yen (GBP/JPY pair), for example, you are actually trading a kind of derivative of the GBP/USD and USD/JPY pairs; therefore, GBP/JPY must be somewhat correlated to one if not both of these other currency pairs. However, the interdependence among currencies stems from more than the simple fact that they are in pairs. While some currency pairs will move in tandem, other currency pairs may move in opposite directions, which is in essence the result of more complex forces.

Correlation, in the financial world, is the statistical measure of the relationship between two securities. The ranges between -1 and +1. A correlation of +1 implies that the two currency pairs will move in the same direction 100% of the time. A correlation of -1 implies the two currency pairs will move in the opposite direction 100% of the time. A correlation of zero implies that the relationship between the currency pairs is completely random.

Reading The Correlation Table
With this knowledge of correlations in mind, let's look at the following tables, each showing correlations between the major currency pairs for the month of March 2005.


The upper table above shows that over the month of March (one month) EUR/USD and AUD/USD had very strong positive correlation of 0.94. This implies that when the EUR/USD rallies, the AUD/USD will also rally 94% of the time. Over the longer term (three months), though, the correlation is slightly weaker (0.47).

In contrast, the EUR/USD and USD/CHF had a near-perfect negative correlation of -0.99. This implies that 99% of the time, when the EUR/USD rallies, USD/CHF will undergo a selloff. This relationship even holds true over longer periods as the correlation figures remain relatively stable.


Yet correlations do not always remain stable. Take USD/CAD and NZD/USD, for example. With a coefficient of -0.94, they had a strong negative correlation over the past year, but the relationship deteriorated over March 2005 for a number of factors, including the Reserve Bank of New Zealand's intentions to resume rate hikes, and political instability in Canada.

Correlations Do Change
It is clear then that correlations do change, which makes following the shift in correlations even more important.Sentiment and global economic factors are very dynamic and can even change on a daily basis.Strong correlations today might not be in line with the longer-term correlation between two currency pairs.That is why taking a look at the six-month trailing correlation is also very important.This provides a clearer perspective on the average six-month relationship between the two currency pairs, which tends to be more accurate.Correlations change for a variety of reasons, the most common of which include diverging monetary policies, a certain currency pair’s sensitivity to commodity prices, as well as unique economic and political factors.

Here is a table showing the six-month trailing correlations that EUR/USD shares with other pairs:




Calculating Correlations Yourself
The best way to keep current on the direction and strength of your correlation pairings is to calculate them yourself. This may sound difficult, but it's actually quite simple.


To calculate a simple correlation, just use a spreadsheet, like Microsoft Excel. Many charting packages (even some free ones) allow you to download historical daily currency prices, which you can then transport into Excel. In Excel, just use the correlation function, which is =CORREL(range 1, range 2). The one-year, six-, three- and one-month trailing readings give the most comprehensive view of the similarities and differences in correlation over time; however, you can decide for yourself which or how many of these readings you want to analyze.


Here is the correlation-calculation process reviewed step by step:

1. Get the pricing data for your two currency pairs; say they are GBP/USD and USD/JPY
2. Make two individual columns, each labeled with one of these pairs. Then fill in the columns with the past daily prices that occurred for each pair over the time period you are analyzing
3. At the bottom of the one of the columns, in an empty slot, type in =CORREL(
4. Highlight all of the data in one of the pricing columns; you should get a range of cells in the formula box.
5. Type in comma
6. Repeat steps 3-5 for the other currency
7. Close the formula so that it looks like =CORREL(A1:A50,B1:B50)
8. The number that is produced represents the correlation between the two currency pairs

Even though correlations do change, it is not necessary to update your numbers every day, updating once every few weeks or at the very least once a month is generally a good idea.

How To Use It To Manage Exposure
Now that you know how to calculate correlations, it is time to go over how to use them to your advantage.


First, they can help you avoid entering two positions that cancel each other out, For instance, by knowing that EUR/USD and USD/CHF move in opposite directions nearly 100% of time, you would see that having a portfolio of long EUR/USD and long USD/CHF is the same as having virtually no position - this is true because, as the correlation indicates, when the EUR/USD rallies, USD/CHF will undergo a selloff. On the other hand, holding long EUR/USD and long AUD/USD is similar to doubling up on the same position since the correlation is so strong.


Diversification is another factor to consider. Since the EUR/USD and AUD/USD correlation is traditionally not 100% positive, traders can use these two pairs to diversify their risk somewhat while still maintaining a core directional view. For example, to express a bearish outlook on the USD, the trader, instead of buying two lots of the EUR/USD, may buy one lot of the EUR/USD and one lot of the AUD/USD. The imperfect correlation between the two different currency pairs allows for more diversification and marginally lower risk. Furthermore, the central banks of Australia and Europe have different monetary policy biases, so in the event of a dollar rally, the Australian dollar may be less affected than the Euro, or vice versa.


A trader can use also different pip or point values for his or her advantage. Lets consider the EURUSD and USDCHF once again. They have a near-perfect negative correlation, but the value of a pip move in the EURUSD is $10 for a lot of 100,000 units while the value of a pip move in USDCHF is $8.34 for the same number of units. This implies traders can use USDCHF to hedge EURUSD exposure.


Here's how the hedge would work: say a trader had a portfolio of one short EUR/USD lot of 100,000 units and one short USD/CHF lot of 100,000 units. When the EUR/USD increases by ten pips or points, the trader would be down $100 on the position. However, since USDCHF moves opposite to the EURUSD, the short USDCHF position would be profitable, likely moving close to ten pips higher, up $83.40. This would turn the net loss of the portfolio into minus $16.60 instead of minus $100. Of course, this hedge also means smaller profits in the event of a strong EUR/USD sell-off, but in the worst-case scenario, losses become relatively lower.


Regardless of whether you are looking to diversify your positions or find alternate pairs to leverage your view, it is very important to be aware of the correlation between various currency pairs and their shifting trends. This is powerful knowledge for all professional traders holding more than one currency pair in their trading accounts. Such knowledge helps traders, diversify, hedge or double up on profits.

Summary
To be an effective trader, it is important to understand how different currency pairs move in relation to each other so traders can better understand their exposure. Some currency pairs move in tandem with each other, while others may be polar opposites. Learning about currency correlation helps traders manage their portfolios more appropriately. Regardless of your trading strategy and whether you are looking to diversify your positions or find alternate pairs to leverage your view, it is very important to keep in mind the correlation between various currency pairs and their shifting trends.

[cornellj]

Hallo CTC,

Good post! I have noted this correlation in The Euro/USD and USD/CHF pairings over the past 5 years of trading them and I am actively using this correlation in using the 2 pairs as hedging instruments against one another. When researching for the closest pairs to do this with I found that the closest move to the Swissy, that I traded, was the EURO/USD pairing. In fact before I used the Euro to trade as a hedge against the Swiss I used market info on the Euro to decide which direction to do a Swiss trade on(this was done because there are a lot more information available on the Euro/USD than the Swiss).

[jezek5]

Eur/Usd and Usd/chf do move quit simular,i trade down trends very well but up trades i am average at best,therefore when dollar is strong i trade Eur/Usd and as of now i am trading Usd/chf it works for me thats all i can say.

[Nonpiker]

Would have been a rough one if you hedged a long EURUSD trade with USDCHF at the start of the year since EURCHF is down about 160 pips. Be careful using that technique when the cross is in play.

[jezek5]

Nonpiker,i hope you are not refering to me as i think hedging is a joke in fx,just cant understand why people do it,by the way your answers are always so good you are one of the best posters on moneytec.