There are "for" and "against" arguments here, and some that seem more informed than others. In my opinion, hedging has one purpose only, and that is to limit risk, which is useful in certain types of correlation trading. For instance, if I buy the AUDUSD I will also sell the NZDUSD, because of the approximate 80% positive correlation between these two pairs. But this assumes, of course, that the AUD is stronger against the USD than the NZD, providing greater upside potential for the AUD than the NZD, allowing me to reach my AUD profit target before the NZD catches up. If, however, prices crash, the NZD is likely to fall faster and further than the AUD due to it being the weaker of the pair, so losses on my AUD trade are partly or even fully offset by profits on the NZD...a win/win outcome!
My correlation hedge strategy is really quite simple. I find two positively correlated pairs that are nearest an 80% coefficient, and then assess which pair is strong, and which is weak. I buy strength and sell weakness, so if prices rise the strong pair will tend to rise faster and further than the weak pair, but if prices fall the weak pair will tend to fall faster and further than the strong pair. If I set my profit target at, say, 40 pips on either side of the hedge, this is what might happen: (1) Prices rise and my strong (buy) pair hit the 40 pip target, whilst the weak (sell) pair loses, say, 30 pips, for a 10 pip net gain, or (2) prices fall and my strong (buy) pair loses 30 pips, whilst my weak (sell) pair hit the 40 pip target, for a 10 pip net gain. There are no guarantees, of course, but you get the idea.
The trick is to find a reliable way to determine strength and weakness, and there are several ways to do this:
(1) Interest Rate Differentials: Until recently, Australian Official Interest Rates were significantly higher than US rates and their New Zealand counterparts, with demand for the AUD creating strength. The strategy was to buy the AUD and sell the NZD. Today, however, NZ interest rates are higher than US and Australian rates, so strength is now with the NZD. The strategy is to buy the NZD and sell the AUD.
(2) Rally/Retrace Pip Measurement: By measuring the number of pips in the most recent rallies and retraces in a pair, we can identify strength and weakness. If one pair rallies by, say, 200 pips and retraces by, say, 50 pips, whilst the other rallies by, say, 150 pips and retraces by, say, 100 pips, the first pair is stronger than the other. The strategy is to buy strength and sell weakness.
(3) Overbought/Oversold Analysis: Using an oscillator, like MACD, Stochastic, or Williams % R, can quickly establish overbought/oversold situations. The oversold pair has more upside potential than downside, so is considered strong. The overbought pair has more downside potential than up,so is considered weak. Again, the strategy is to buy strength and sell weakness.
Keep in mind that a strong pair need not necessarily rise, or a weak pair fall, for this type of strategy to yield profits. As long as one moves faster and further than the other, then there is profit potential...regardless of which way prices eventually move. Again, there are no guarantees, but you can at least stack the odds in your favour.
Finally, I see the use of 5-min and 15-min timeframes here and elsewhere, which are simply too short for meaningful correlation hedge analysis. You just won't get the accuracy needed for consistent profitability. I use weekly correlation coefficients calculated over a 50 week period, whilst trading and applying my strength/weakness analysis to the H1 timeframe. Here's some recent results:
Month of September 2016 - Pepperstone
First week October 2016 - IC Markets
My correlation hedge strategy is really quite simple. I find two positively correlated pairs that are nearest an 80% coefficient, and then assess which pair is strong, and which is weak. I buy strength and sell weakness, so if prices rise the strong pair will tend to rise faster and further than the weak pair, but if prices fall the weak pair will tend to fall faster and further than the strong pair. If I set my profit target at, say, 40 pips on either side of the hedge, this is what might happen: (1) Prices rise and my strong (buy) pair hit the 40 pip target, whilst the weak (sell) pair loses, say, 30 pips, for a 10 pip net gain, or (2) prices fall and my strong (buy) pair loses 30 pips, whilst my weak (sell) pair hit the 40 pip target, for a 10 pip net gain. There are no guarantees, of course, but you get the idea.
The trick is to find a reliable way to determine strength and weakness, and there are several ways to do this:
(1) Interest Rate Differentials: Until recently, Australian Official Interest Rates were significantly higher than US rates and their New Zealand counterparts, with demand for the AUD creating strength. The strategy was to buy the AUD and sell the NZD. Today, however, NZ interest rates are higher than US and Australian rates, so strength is now with the NZD. The strategy is to buy the NZD and sell the AUD.
(2) Rally/Retrace Pip Measurement: By measuring the number of pips in the most recent rallies and retraces in a pair, we can identify strength and weakness. If one pair rallies by, say, 200 pips and retraces by, say, 50 pips, whilst the other rallies by, say, 150 pips and retraces by, say, 100 pips, the first pair is stronger than the other. The strategy is to buy strength and sell weakness.
(3) Overbought/Oversold Analysis: Using an oscillator, like MACD, Stochastic, or Williams % R, can quickly establish overbought/oversold situations. The oversold pair has more upside potential than downside, so is considered strong. The overbought pair has more downside potential than up,so is considered weak. Again, the strategy is to buy strength and sell weakness.
Keep in mind that a strong pair need not necessarily rise, or a weak pair fall, for this type of strategy to yield profits. As long as one moves faster and further than the other, then there is profit potential...regardless of which way prices eventually move. Again, there are no guarantees, but you can at least stack the odds in your favour.
Finally, I see the use of 5-min and 15-min timeframes here and elsewhere, which are simply too short for meaningful correlation hedge analysis. You just won't get the accuracy needed for consistent profitability. I use weekly correlation coefficients calculated over a 50 week period, whilst trading and applying my strength/weakness analysis to the H1 timeframe. Here's some recent results:
Month of September 2016 - Pepperstone
First week October 2016 - IC Markets
