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CREATING A HEDGE POSITION TO ENABLE SCALE-TRADING OF

FOREX CURRENCY PAIRS

Premise

The currency spot markets are not typically suitable to a Scale-Trading venture. Scale-Trading
is normally conducted using commodity contracts which are influenced by supply

and demand factors. Normally, in traditional Scale-Trading, one would begin acquiring
commodity contracts when prices drop to the lower one-third of a 10-year price range.

One accumulates contacts on a defined scale as the price drops, and sells on a defined scale as
the price rises. Prices rarely drop straight down or rise straight up. It is normal for

volatility to be a factor as the price moves up or down. Volatility is frightening to most


traders, but is most profitable to Scale-Traders, as multiple profits can be secured during

prolonged price oscillations. This is where an opportunity to Scale-Trade the currency spot
markets exists - VOLATILITY.

Aside from being the most liquid market in existence, the currency spot market is also quite
volatile, allowing for daily oscillation profits for a properly executed strategy. There

are so many influences on the currency spot market that one must create a “hedge” to be able
to “Scale-Trade” this market. A hedge can be created by initiating two opposing

positions (one buy, one sell), with different, but similar currency pairs. These pairs must share
a currency, and they must trend in similar fashion. They also must share the same

pip value.

Once the pairs are selected, two legs of the hedge must be taken. One leg will be considered
the “long” leg, and once will be considered the “short” leg. This creates the

hedge needed by playing all sides of the market simultaneously. Once this is in place, one can
begin taking advantage of the inherent volatility in the spot currency market, without
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undue risk.

Building the Hedge

For our purposes, we will be using the GBP/USD and EUR/USD currency pairs. Both are
paired with the US Dollar, both trend in a similar manner, and both share the same pip

value ($10 for a full lot). For these reasons, one could build a correct hedge using these
currency pairs, and with a few refinements, use this hedge to “Scale-Trade” the market.

Refinements

As with anything, timing is critical to any Scale-Trading venture. You must be in the market
only when sufficient trading volume exists in order to properly execute trades.

For our purposes, that time would be from 8am to 11am EST. This is the period when the
European markets are closing down, and the US markets are opening. Many traders refer

to this period as the “Power-Hours”, as the volume, liquidity, and volatility are at their peak.
To take it a bit further, the most powerful days are Tuesday and Wednesday, with

Monday and Thursday a close second. Sundays and Fridays are NOT a good time to Scale-
Trade, as the volume is low, as is volatility. Never trade overnight, as it is too

unpredictable during the Asian-European crossover (2am to 5am EST), and the “Dead-Zone”
from 5am to 7am EST, when hardly any trading is occurring. Furthermore, one

must be cautious when news releases are in play, typically released at 8:30am EST , as wild
and unpredictable price moves can and do occur - consult an accurate economic calendar

and avoid opening trades on these days.

Next you must consider acceptable profit-taking. If you set a profit target (scale) that is too
small (tight), slippage will erode your profits. If you set your profit target too high

(a wide scale) you run the risk of missing many oscillation profits, which is the lifeblood of a
successful Scale-Trading venture. For our purposes, a 10 to 15 pip target (scale) would

provide adequate room for price slippage, as well as enough tightness to execute multiple
oscillation trades.
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Manual vs. Automated trading…While you could definitely Scale-Trade the spot currencies
manually, there is an argument for automating your trading. First of all,

automation helps remove the “emotional” element of trading that can negatively affect one’s
success. When you are trading manually, you have the power to stray away from

your system, which usually results in poor results. Automation helps avoid this. Secondly, it is
just more efficient to automate, and you will get better executions. During periods of

very high volatility you will most likely miss many profitable trades simply because you
couldn’t click your mouse fast enough…again, another reason to automate your Scale-

Trading. There are many ways to automate this strategy. I am not a programmer, so I would
utilize Expert Advisors for Metatrader4. You will have to decide which is best for you.

One of my readers has developed an Expert Advisor for this strategy. I use it and it works
quite well. You can get the EA here.

Money Management

Due to current margin requirements for both pairs, we are going to use $5000, per leg, for a
total of $10,000. You should open two separate accounts at different brokerages.

Put $5000 in one account and $5000 in the other (this is for trading full-lots. For mini-lotsit
would be $500 for each account). To initiate the Hedge, you will take two opposing

positions in each account.

Progression - work in $10,000 increments ($1000 for minis). Add positions as your capital
increases by these increments. Once you reach your desired level (I would not

exceed $100,000 total), simply “peel-off” your profits monthly and maintain your “base
trading capital.” Pour the excess proceeds into the instruments of your choice. These days

I would go for safety ( Brokered CD’s, Municipals, Treasuries, etc.).

Actual Trading

Okay, so let’s get to where the rubber meets the road: We are going to open two “legs” - In
account 1 we will buy the GBP/USD and sell the

EUR/USD. This will be the “long” leg of the hedge. In account 2 we will sell the GBP/USD
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and buy the EUR/USD. This will be the “short” leg of our hedge.

We will open both legs at 8am EST and close them at 10:30am EST, regardless of where they
stand at 10:30am. We will take profits on each leg when the difference between the

pairs shows a positive 10 to 15 pips, and immediately reopen the trade as we started. Our goal
is to “ride out” the volatility so prevalent in the market during this time period, aka

“The Power Hours” and then shut it all down at 10:30am EST.*

*Note - if you are automated this will require little more than you just monitoring the
situation, making sure everything is working properly, and, in my case with Expert

Advisors, manually override the automation at 10:30am EST and close the legs down
manually.

Remember, you will only trade on Monday, Tuesday, Wednesday, and Thursday. DO NOT
trade on Sundays or Fridays. DO NOT trade overnight. Trade ONLY the “Power

Hours” as described above. Also, I encourage you to avoid trading on days when a scheduled
economic news release is going to occur. All decent brokers have an free

economic calendar available to clients. Get one and pay attention to it.

It is impossible to predict how many trades you will take each day, and what your profits will
be each day or week. Be wary of any system that promises a certain amount of pips or

profit…the markets are way too dynamic to predict. Just concern yourself with taking
advantage of the volatility in the markets, which is as sure as the rising sun, and let your

Scale-Trading approach capture those oscillations as they occur.

Most likely you will have a series of multiple oscillation profits, and then at 10:30 EST you
will close each leg down at a small loss. That is fine, as what matters is your net for the

trading day. Ex. 16 oscillation profits at 12 pips each , less 2 losses of 9 each at 10:30am EST
when you close out. +192 less (-18) for a net of +174 pips for the session.
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Conclusion

This approach to trading has been proven successful in the commodity markets for over 40
years. By building a proper Hedge, and following some simple principals and guidelines,

we can approach the spot currency markets with a form of Scale-Trading that has all of
theessential elements for success. Good trading…

John C. Cunningham, phd.

New York