MISJUDGEMENT OF HEDGING, GRID TRADING AND USE OF SL

After 2 well-known grid-trading strategies have blown up, almost every self-appointed trading expert jumps in bandwagon of thrashing the usage of grid trading and highlights the importance of actual SLs. The same individuals tend to mention a term hedging, without properly understanding what's behind that. FX Sumo is here to clear the confusion and give a more rational perspective...:)


Before we start this, we should mention that our current FX Sumo trading methods employ grid trading elements, thus, there could be someone implying that our view is biased. Although there is a clear logic behind such thinking, let us assure that throughout this article we will remain as objective as possible.


What is grid trading? - trading methodology, based on which positions in the same currency pair are opened if the prices deviate from first position, usually, on the negative side. Basically, You add up on Your losers, hoping that the market will eventually turn around and ride in Your favor. Here is visual example:


Usually, this type of trading is connected with semi-martingale trading elements, more specifically, increasing the sizes of each following position.


What is hedging (guys, read this - 95% of You are interpreting this the wrong way)? - to hedge a specific position, trader must look for alternative asset (in our case - currency pair) through which to minimize risks of the existing position.

Example:

Let's say we have a long EURUSD position, but the price is falling. For some reason, we are not willing to close this position, however, we want to minimize the risks of it going lower. Our gameplan here would start by understanding why the price is falling - either it is weak EUR or strong USD. Afterwards, if EUR has weakened and there are risks of this continuing, we should look for an another currency, which is as strong as possible, and short the pair; if the USD has strenghtened and there are risks of this continuing, we should look for an another currency, which is as weak as possible, and long the pair. Here is visual interpretation:


Most of the traders wrongly believe that hedging activities are tied with the currency pair, in which a position is already open - to hedge a long EURUSD position, You would need simply to open a sell in the same pair. These individuals misjudge the reason why brokers allow to open positions in the same currency pair at the same time on both directions -> purely monetary reasons, no connection with hedging whatsoever.

Having both long and short positions on EURUSD doesn't solve a thing - this simply puts the existing result on freeze, while You still keep paying swap fees to Your broker. Moreover, the question of which of these positions should be removed remains unsolved, that's why both Twilight and Dragon crashed. Both of them thought that they were doing some hedging, when actually they were just juggling the existing positions and guessing, which of the trades should remain open and which should be closed.


After this lenghty discussion of terms, it is important to discuss how these trading elements affect real time trading. With regards to hedging, there is not much to say - 95% of existing strategies DO NOT USE any hedging at all, as their authors have 0 idea of what actual hedging means for the forex markets. When analyzing grid trading, things get much more complicated and fun.:)

In order to compare grid trading with "correct trading", we should formulate a few assumptions that would characterize a typical strategy of each type:

  • Grid trading - new positions are opened when result on the existing ones worsens (like in that visual example); correct trading - no more than 1 position is open on the same currency pair at the same time;
  • Grid trading - no usage of SLs, but have TP conditions; correct trading - have SL and TP for each position;
  • For sake of fun, let's assume that only grid trading employs semi-martingale elements. Theoretically, correct trading could have that as well -> after each SL, increase the size of a next position till positive outcome is being reached.

For those of You who would like to see how these strategies look in real trading, here are examples:

Grid trading growth and % of profit and loss trades:


Correct trading growth and % of profit and loss trades:


Higher % amount of profit trades (usually, above 85%) and smoother balance curve indicates that almost certainly trading strategy possess grid-trading elemets and/or non-existance of active SL for each trade. Is it a bad thing? And how grid-trading matches up versus correct trading? This is where things get very interesting:


Which of these 2 strategies is more suitable for You? - Well, there is no 1 correct answer. This is not as obvious choice as most of You would have expected, therefore, the title of this article is what it is -> You should overvalue the opportunities that correctly applied grid system provides. What is more, You should realize that Stop-loss can either be saviour, or curse for Your trading strategy.


That's all from our side. If You have any suggestions or You disagree with some of the ideas, feel free to leave Your comment below!

Best of luck,

FX Sumo