Hello,
In view of the general level of interest and the number of inquiries I've received from many of the folks here, I've decided to start a thread to discuss on a low-risk hedge trade strategy which I've recently developed.
The idea behind this strategy is derived partly from the FR/FFS type partial hedge methods, which is extremely risky by nature, and partly from the impeccable hedge methods, which is virtually 100% safe, but is rather limited in earning potential.
With the FR/FFS type hedge strategy, a partial hedge is formed as a result of correlation between major currency pairs. For currency pairs that are strongly correlated, the differences in pip movements between each currency pair in hedge are usually small, but can fluctuate due to changes in the economic climate. For currency pairs that are less correlated, the differences in pip movement are larger. This give rise to a double-edge sword scenario, where the edge can be used for you, or against you - shredding you into pieces! For currency pairs that have stronger correlation, the effects are usually more mellow. However, this does not mean that you are on safe grounds, for there is NO GUARANTEE that the correlation between the currency pairs will stay forever.
Take for instance, GBPUSD vs USDCHF. These two currency pairs used very well correlated, fetching a negative correlation coefficient as high as -0.80. However, the recent changes in economic climate caused a huge drop in the correlation, leading to extremely large pip movement differences between the two pairs. Even EURUSD vs USDCHF, which has the tightest correlation among the major currency pairs along with EURJPY vs EURCHF, was quite seriously impacted as well. Will the tight correlation return once again? Maybe, but maybe not. But even if it return tomorrow, can anybody guarantee that it will not be lost once more? Nobody can predict for sure.
So, what can hedge traders do about this catastrophic scenario? What if they continue to operate the way they used to? Will their account will be wiped out one day, like the many whom got margin call between Jan to early this month? This is a very possible scenario... Murphy's Law states : "If things can happen, they WILL happen..."
Now, back to the strategy I'm going to introduce. While this strategy is based on the idea of hedging, it has been designed to avoid dependence on correlation between currency pairs, which is the single reason why FR/FFS type hedging methods fail. However, its also not a Buy/Sell same lot with same currency pair method. The reason why the latter method won't work is because the pip movement difference is zero. Coupled with the differences in interest rates between Buy/Sell same lot for same currency, which produces net negative interest, it will be a slow death process.
Between these two extremes, however, there is a ray of hope where one can generate sizable returns rather safely behind a solid hedge. So, how does the method work? First of all, the method is not dependent on hedging between separate currency pairs, which is often unreliable. It works by Buy / Sell with the same currency pair, however, in unequal lots. With this configuration, the pip movement difference is a zero-sum game, however, by buying and selling unequal lots, the pip cost for each trade is different. Hence, interest can be generated based on this difference, as the hedge pair is now structured in your favour. On top of that, opportunities for cash-grabs are expected, much akin to the positive side of FR/FFS type strategies, however, in a much less risky environment. Drawdowns are also expected, however, depending on how the lots are sized for each opposing trade, the risk can be minimal. This is mainly due to the fact that the hedge is operating on a zero-sum pip movement difference concept.
The currency pair chosen for this strategy is GBPJPY, not only because it fetches the highest interest rate per lot, but also because of the low differences (in term of %) between the Buy/Sell swap rates.
I have developed a calculator for structuring the trades. Please refer to the Excel spreadsheet attached, which contain instructions for using the calculator.
I have not tested the strategy thoroughly myself as it was a newly developed concept. I would appreciate any inputs from the esteemed members of this forum. In the near future, I am planning to develop an EA for this method.
Edit (March-24-2007) for R1.0:
I've included additional calculations for USDJPY. See attachment.
Edit (March-26-2007) for R1.1:
Fixed some minor calculation errors;
Re-defined the Bias so that it is now adjustable in terms of percentage;
Added calculation for Risk in terms of $/pip.
Edit (March-26-2007) for R1.2:
Fixed major error in lot size calculation. Careless mistake... Verified and checked against broker's data. Should be correct now.
Edit (March-26-2007) for R1.3:
Another careless mistake... *sigh*... Fixed.
Status:
Experiment closed. Reason: Conceptual mistake
Linear Mode
