Hedging & Diversification Tool

What this Indicator Does

• Finds correlated pairs for hedge trading
• Helps you to diversify your account and risk
• Gives the “hedge value” of any instrument
• Gives the “hedge ratio” needed and trade direction
• Works at any time scales

How this can benefit your trading

Knowing the relationship between different trading instruments is essential both for risk management and for hedging. This tool will scan through all instruments in your Metatrader market watch window. It will then tell you the relationship each symbol has to the current chart symbol. It will tell you:

• Instruments that move in the same direction (positive correlation)
• Instruments that move in the opposite direction (negative correlation)
• The strength of the relationship over different time periods

This information can be used to setup hedge trades. It can also be used to diversify your portfolio to avoid trading linked pairs in the same direction.

Hedging

As part of a hedging strategy you may need to find hedge pairs: that is instruments that move together under a certain relationship. For example the relationship between CADJPY and Crude Oil is well known. Higher oil prices tend to result in CADJPY moving higher while lower oil prices tend to result in CADJPY moving lower. This is an example of positive correlation.

Hedging strategies involve trading related instruments usually in an effort to reduce volatility.

Example: AUDNZD

For example the figure below shows the indicator output when it is used on the AUDNZD chart (Australian Dollar/New Zealand Dollar):

Figure 1: Hedging results for AUDNZD © forexop

The tool shows that the strongest relationship to AUDNZD over the period is Gold (XAUUSD) and it has strength of 0.79.

The indicator lists the symbols from the Market Watch window as follows:

This shows the instruments with the strongest relationships, either positive or negative. The table below shows the relationship over different timeframes (the times can be chosen in the setup).

The best hedge pair is listed as:

Best 1 month hedge is short 6.8173 XAUUSDpro

The best 1 month hedge is given as Gold (XAUUSD) and the advised trading ratio is:

1 Long x AUDNZD : 6.82 Short XAUUSD

Reducing risk by Diversification

Of course the goal is not always to hedge but to avoid trading in pairs that have strong relationships. That is, to use diversification. Diversifying trades can help reduce overall risk exposure and even out returns.

Example: Diversifying Trades

For example, suppose a trader takes a long position in NZDUSD and is now considering trading either AUDJPY or EURJPY based on their chart setups.

Figure 2: Using the tool to check for relationships © forexop

But loading the indicator for NZDUSD shows that both of these pairs have a very strong short term correlation. So in fact the trader would gain no diversification by adding these to his trading book. And therefore there’d be no advantage to entering the trades. In fact, he’d be nearly tripling the exposure and value at risk by adding them (assuming they’re traded in the same direction).

If we now change the mode to “show diversifying trades”, the indicator shows the following:

Figure 3: Best trades for diversification © forexop

This shows that both EURCAD and EURGBP have low correlation over the period being considered. Therefore from a diversification point of view, these would be better trades.

Settings

The settings allow you to customize the outputs to your trading requirements, including trade size, trade direction and time frames. You can also switch between showing hedging trades and showing diversification trades.

Figure 4: Indicator input settings © forexop

• Compare symbol (blank to find best hedge): Leave blank to find best trade
• Long comparison period: Your long term trading time frame
• Medium comparison period: Your medium term trading time frame
• Short comparison period: Your short term trading time frame
• Symbol type: Any, Forex, Futures, CFD
• Trade side: Which trade side should be examined (long or short)
• Use average returns over this many bars: How many bars are processed in a cycle
• Ignore related symbols: Ignore symbols with same base/quote
• Max Symbols: Watch this many symbols from MarketWatch window
• Mode: Show hedging trades or diversification trades

Compatible with Metatrader 4 and Metatrader 5.

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