HEDGING THE HEDGE
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WHAT DO YOU THINK ABOUT HEDGING THE HEDGE,
COMPARE EURUSD/GBPUSD RATIO1 TO GBPUSD/AUDUSD RATIO2. PERFORMING CORRELATION ANALYSIS ON RATIO1 VS. RATIO2 GIVES NEGATIVE CORRELATION(NOT ALWAYS). THE REASON FOR THIS STRATEGY: AFTER DOING PAIRS-TRADING FOR A WHILE I NOTICED THAT SOMETIMES YOU ENTER AND THE PROFIT IS NEGATIVE BETWEEN TWO INDIVIDUAL INSTRUMENTS, AND TO CANCEL OUT THAT RISK IS TO HEDGE THE HEDGE, SO THAT ONE PAIR IS NEGATIVE WHILE THE OTHER IS POSITIVE.
EXAMPLE, NORMALLY YOU WOULD HEDGE EURUSD WITH GBPUSD, BUY EURUSD AND SELL GBPUSD!
NOW SUPPOSE THE HEDGE GOES AGAINST YOU, AND YOU ARE NEGATIVE ON YOUR PROFIT..... .... HERE IS WHERE THE OTHER HEDGE WILL BE POSITIVE.
SO TO HEDGE THE HEDGE, I NOTICED THAT RATIO1 VS. RATIO2 IS NEGATIVE CORRELATION, WHICH MEANS WHEN THE RATIO OF RATIO1/RATIO2 IS 2 STANDARD DEVIATIONS AWAY FROM MEAN, YOU WOULD SELL RATIO1 AND SELL RATIO2 OR BUY RATIO1 AND BUY RATIO2.
SO FOR EXAMPLE IF RATIO1/RATIO2 IS OVERBOUGHT, YOU WOULD SELL RATIO1 AND SELL RATIO2 WHICH EQUALS, SELL EURUSD, BUY GBPUSD, SELL GBPUSD, BUY AUDUSD. SINCE EACH RATIO OF INDIVIDUAL INSTRUMENTS HAVE POSITIVE CORRELATION(EURUSD AND GPBUSD HAVE POSITIVE CORRELATION, GPBUSD AND AUDUSD HAVE POSITIVE CORRELATION), IT SEEMS THAT THE RISK IS TOTALLY HEDGED. i HAVE BEEN TESTING THIS AND WHEN YOU HEDGE IN GENERAL THE RETURNS ARE LESS, AND WITH THIS HEDGE THE HEDGE CONCEPT THE RETURNS ARE EVEN SMALLER, BUT YOU ARE PROTECTED AGAINST NEGATIVE PROFIT ON THE SIMPLE HEDGE WHERE YOU ONLY SELL EURUSD AND BUY GBPUSD. BECAUSE WITH THIS: WHEN ONE PAIR IS NEGATIVE, THE OTHER PAIR IS POSITIVE...... ...............................BECAUSE OF NEGATIVE CORRELATON BETWEEN RATIO1 AND RATIO2... OFCOURSE, IF ALL CORRELATIONS START BREAKING DOWN, AND ALL OF THE PAIRS START SWINGING LIKE CRAZY, THEN YEAH THAT IS THE RISK, BUT I'M ASSUMING THAT CORRELATION IS HIGH ON DIFFERENT TIME FRAMES.....
WHAT ELSE I NOTICED IS THAT YES THE GPBUSD DOES CANCEL IT SELF OUT, BUT YOU CAN'T LOOK AT IT LIKE THAT, EACH PAIR IS HAS IT'S OWN PERFORMANCE!
SO YOU HAVE TO LOOK AT IT AS PAIRS, EURUSD VS GBPUSD, AND GPBUSD VS AUDUSD. AND NOT ONLY THE TWO PAIRS ARE HEDGED, BUT ALSO NOTICE THAT EURUSD AND AUDUSD IS HEDGED, SINCE IT'S SELL EURUSD AND BUY AUDUSD.......................... I DONT KNOW IF THIS WILL MAKE ANY SENSE TO ANYONE...
ANOTHER COOL THINGS ABOUT THIS STRATEGY IS THAT THE SWAP CANCELS IT SELF OUT 100%, BETWEEN THE 4 POSITIONS, IF ENTERED ON OVERBOUGHT WITH NEGATIVE CORRELATION THE SWAP IS ALWAYS ZERO ASSUMING THAT THE INTEREST RATES STAY THE SAME. SO THE PROFIT IS TOTALLY DEPENDENT ON PERFORMANCE OF THE TWO RATIOS..................... .... ...