Do I Need to Hedge My Trades?

Hedging is unnecessary in the short-term as correlations are typically stronger over the long-term. However, even on longer-term opportunities, diversification could be a better approach.

Hedging for Short-Term Opportunities

I once watched a trader who would open a trade each morning and immediately open a second one. They said they were "hedging." But it seemed like they were just opening a random second trade, thinking they had to hedge every time. But that’s not how hedging works.

Hedging reduces the risk of price movements by offsetting a position with another that has an inverse correlation. Correlation refers to how two assets move in relation to one another:

• Positively correlated assets move in the same direction.
• Negatively correlated assets move in opposite directions.

‍

However, over the short-term, these correlations don’t hold up and that means a hedge may not perform as expected. For example, a pair of assets that typically move inversely over the long term might move together in the short term. 

Another thing to consider in liquid and relatively stable markets like EUR/USD, these correlation changes are often minimal, making the cost of hedging outweigh its benefits.

Hedging for short-term opportunities also doesn’t align with taking advantage of immediate price movements. If you believe in your initial trade direction, hedging against it doesn't make much sense, it’s like betting against your own decision. 

The Cost of Hedging

Another issue with hedging in short-term trading is the additional costs. Each trade you place comes with transaction costs, which may include spreads, commissions, and potential slippage. 

If you're opening two positions, one to take advantage of an opportunity and the second as a hedge against it, you're paying to open two trades. This reduces your potential profits, especially since the hedge may not be as effective due to the unreliable correlations in the short-term.

Hedging for Longer-Term Opportunities

Hedging becomes more useful in long-term trading, where correlations are more reliable. However, it’s most useful when trying to gain exposure to a specific part of an asset.

For example, shorting healthcare companies reliant on government contracts while remaining neutral on the overall healthcare sector. That trade can target a specific risk.

However, for trading there's often a better option, diversification. Diversification refers to spreading out your investments across a variety of assets to reduce the impact of any one asset's poor performance. Instead of hedging, where you are actively trying to offset risk with opposing trades, diversification relies on the lack of correlation between your positions.

For trading, this could mean you avoid opening too many trades on correlated assets. Or if you spot multiple opportunities, you spread the risk between them using a lower position size on each of them.

However, this is only usually a concern if you plan on holding trades for weeks or months. If you’re short term trading, there’s not much reason to worry about hedging or diversification. Don’t overcomplicate things if you don’t need to.