Risk/Reward Hedging
In a follow up to the hedge trade talked about 2 weeks ago, we want to also address the risk reward reasons for doing the hedge. As mentioned, the best way to hedge, was to focus on the currency that recently showed the most strength and the most weakness against the currency being hedged.
In the example from 2 weeks ago, we hedged the US dollar by picking the AUSUSD as the weakest against the dollar and the NZDUSD as showing the most strength. We sold the AUDUSD (see below left) and we bought the NZDUSD (see below right.)
The NZDUSD had found temporary support and was consolidating. The risk/reward on the NZDUSD was we were buying at a support level. If the trade didn’t work out, we would have a stop loss around or slightly below support leaving us with little risk or loss. Our potential gain would be significantly farther away at resistance.
For the AUDUSD, we had a strong downward trend, which if it went against us would be hard to reach. Usually, I look at a stop around the 18 moving average, which in this case would represent a small loss but lots of potential if our downward trend continues.
As it turns out, both positions are showing a profit. We can adjust our stops to lock in our profit.
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