Now the good news is that developing currency trading strategies, whether for spread betting or in the spot market, is much easier than in the previous example for commodities, where we were cross hedging in different markets. With forex, we have the option to hedge between all the various currency pairs and indeed this is the FX strategy that I use myself when trading in the spot markets. In addition, spread betting also gives us the opportunity to hedge between currency options and currency spot markets, so let’s look at some simple forex spread betting strategies for our low risk trading.
As with all the other strategies we have looked at so far, the key to our strategy is to understand the correlation between the currency pairs, and one of the most popular and well defined is that between the euro vs dollar ( EUR/USD ) and dollar vs Swiss ( USD/CHF). If we start by looking at the daily or weekly chart for each currency pair, we soon realise that the two currency pairs are inversely correlated. As the euro vs dollar moves lower, then the dollar Swiss moves higher as a general rule, and normally correlates between 0.9 and 0.95. However, as I outlined in my introduction to correlation, these relationships can and do change over time, and this is one that has slipped slightly in the last few weeks, partly due to intervention by the Swiss central bank, which is always an issue when trading the currency markets. This relationship has also suffered following the turmoil in Europe as the markets react to the possibility of a default by one of the EU member states. This of course has affected both currency pairs ( along with others) upsetting the historical relationships of the past, causing correlations to breakdown as a result. However, longer term this is one that will always come back into alignment once the markets have calmed following the recent volatility, so let’s have a look at how we can use this relationship to set up our forex trading strategy.
For our example, assume we are bearish on the EUR/USD longer term, and as a result are looking to place a sell order for this pair, then in order to hedge ( and remember these pairs correlate inversely) then we need to place a sell order on the USD/CHF to set up our spread betting hedge. Most of the spread betting companies will quote to the fourth decimal point, in other words one pip, so we do not need to worry about different unit rates. In addition there is no exchange conversion to worry about as in the spot market, where the pip rate between pairs will vary when trading the hedge. The only thing you will see is that the spreads quoted for the USD/CHF will probably be slightly wider than those for the EUR/USD.
So we can now set up our spread betting hedge in forex, and sell the EUR/USD at £5 per point ( per pip ) and also sell the USD/CHF at £5 per point which gives us our balanced hedge. Whilst the correlation between the two is good, it is not perfect, allowing us to benefit from the hedge should we be correct in our market assessment. In addition we could also give this hedge a bias, increasing the ratio to 2:1, and betting £10 per point on the EUR/USD whilst hedging with only £5 on the USD/CHF ). Of course the more bets placed, then the greater the spread costs of the hedges, so please bear this in mind when preparing your spread betting strategies.
Now in the forex market there are many currency pairs that correlate very well and some of those to consider would be the GBP/USD and EUR/USD which historically correlated positively, but this correlation has broken down in the last year or so, and the EUR/USD and the USD/DKK. Always make sure that the point value you are betting is the same on each pair, as some currency pairs in the spot market are only quoted to two decimal places such as the USD/JPY, so do double check. Also make sure that your spread betting company allows hedging in this way – many spot forex brokers do not, and if this is an issue then simply open two spread betting accounts with two different companies.
Finally, there is another way to hedge in the forex market, and that is against the US dollar index. This is an index which tracks the US dollar against a basket of other major currencies and is quoted on a chart, just like any other indice. As a result we can use this index as our hedging balance, but make sure that you get the correlation with the index in the correct direction. The USD index will rise on dollar strength, which in turn will cause currency pairs such as the euro dollar and pound dollar to fall as a result, as in these pairs the US dollar is on the opposite side of the trade, so selling the euro or pound, results in buying of the dollar. In the case of the euro dollar , you would sell the currency pair as well as sell the USD index for dollar strength, and buy both for US dollar weakness. The only issue here is that you will need to ensure that the unit price of your index bet is equivalent to your pip unit on the currency, and as in the example for the commodities, you will need to make sure that the relative movements of both markets are similar and calculate your weighting accordingly. The best way to do this is to watch the two markets for a period and record the daily movements for each. Based on your studies you will then have a good basis on which to weight your trade, and this approach is valid for all hedging strategies in related markets – take your time, check the daily movements on each, and then work out the weighting for your hedging accordingly, remembering to check the unit rates quoted by your spread betting company. If you do make a mistake ( and I have several times ) then simply close out, check your records, check the unit rates and start again! Check early and check often is my motto, and by a combination of analysis, trial and error and experience, you will develop better and better hedges which will stand you in good stead for the future.
Now let’s look at the spread betting strategies for trading in indices.