Why Hedge?

Hedging reduces drawdowns and smooths returns by offsetting risk. It does not eliminate risk; it trades some upside for downside protection and psychological stability.

Hedge Types

Volatility Measurement

ATR (Average True Range)

• Measures typical range in pips over N periods (e.g., 14). Good for setting stops and hedge sizes.
• ATR multiple stops: SL = k × ATR (k ≈ 1.0–2.0 depending on timeframe).

Realized (Historical) Volatility

• Standard deviation of returns over a lookback (e.g., 20/30 days). Expressed annualized or per‑period.
• Useful for comparing instruments and sizing portfolio‑level hedges.

Implied Volatility (IV)

• Derived from option prices; represents market‑expected future volatility.
• High IV → hedges cost more but are more valuable; low IV → cheaper protection but may precede expansion.

Hedge Sizing — Step‑by‑Step Math

Define your exposure (pip value × stop distance or ATR multiple) and match it with a hedge sized to offset a chosen % of risk.

Example A — Direct Hedge (EUR/USD)
Position: Long 0.40 lots EUR/USD
Pip value (1 lot) ≈ $10 → for 0.40 lots ≈ $4/pip
Hedge plan: Neutralize 50% of exposure during CPI
Hedge size = 0.40 × 50% = 0.20 lots short EUR/USD
Remove hedge after spreads normalize and direction is clear.

Example B — Cross‑Hedge with GBP/USD
Position: Long 0.40 lots EUR/USD (≈ $4/pip)
Empirical beta: GBP/USD moves ~0.8× vs EUR/USD intraday
Target hedge = 50% exposure → need ~$2/pip offset
GBP/USD pip value (1 lot) ≈ $10 → 0.20 lots = $2/pip
Apply beta: $2 × 0.8 = $1.6 effective → shortfall
Adjust size: $2 / 0.8 = 0.25 lots short GBP/USD for 50% effective hedge

Example C — Options Hedge (if available)
Position: Long EUR/USD spot
Buy EUR put (USD call) with delta ≈ −0.3 sized so |delta × nominal| ≈ 0.5 of spot exposure
This provides convex downside protection with limited premium cost.

When to Hedge & When Not To

• Hedge: concentrated exposure (e.g., net long USD across 3 pairs), pre‑event risk, volatility spikes, or during platform/EA issues.
• Avoid hedging: small positions where costs dominate; when the hedge would simply lock a loss without strategic benefit.

Costs, Basis Risk & Hedge Efficiency

• Costs: spread, commissions, swaps/financing, option premium.
• Basis risk: cross‑hedges won’t track perfectly; correlations change, especially in stress.
• Hedge efficiency: measure reduction in PnL volatility vs cost. Keep hedges only if net benefit is positive over time.

Operational Procedures

1. Document a Hedge Playbook: triggers (news/calendar/limits), type (direct/cross/options), size %, unwind rules.
2. Set alerts before events; pre‑calculate sizes (lot templates) to avoid errors during volatility.
3. Log hedge adds/removals with time, spread, and rationale to evaluate efficiency.

Worked Portfolio Example — Digit‑by‑Digit

Portfolio:
Long 0.25 lots USD/JPY (long USD)
Short 0.20 lots EUR/USD (long USD)
Short 0.15 lots GBP/USD (long USD)
Net view: heavily long USD
Goal: reduce USD bucket risk by 50%

Compute pip exposure (per pip):
USD/JPY 0.25 lots ≈ $2.25/pip (varies by price)
EUR/USD 0.20 lots = $2.00/pip
GBP/USD 0.15 lots = $1.50/pip
Total ≈ $5.75/pip long USD

50% hedge target ≈ $2.875/pip
Add short USD exposure via: long EUR/USD + long GBP/USD, or short DXY proxy if available.
Option: Long 0.15 lots EUR/USD ($1.5/pip) + Long 0.14 lots GBP/USD (~$1.4/pip) → ≈ $2.9/pip offset.

From Volatility to Risk Limits

• Increase hedge size when ATR or realized vol exceeds your threshold (e.g., ATR > 1.5× 6‑month median).
• Reduce hedges as volatility normalizes to avoid paying carry/spread unnecessarily.
• Use time stops for temporary hedges (e.g., auto‑remove after 60–120 minutes post‑event unless extended by new signal).

FAQ

Q: Is hedging the same as closing?

A: No. Closing removes exposure and locks PnL. Hedging offsets exposure while keeping the original trade alive until uncertainty passes.

Q: Can I hedge during spreads widening?

A: Yes, but be aware costs may spike around news; size hedges conservatively and avoid multiple toggles.

Q: What if my broker forbids direct hedging?

A: Use cross‑hedges or reduce/close the position; check terms on netting vs hedging accounts.

Next Steps

Create a one‑page Hedge Playbook with triggers, sizing rules tied to ATR/volatility, and unwind procedures. Backtest with historical events (CPI/NFP/FOMC) to estimate costs vs protection. Implement alerts and templates to execute cleanly under pressure.