Hedging and Virtual Hedging

Some strategies, especially grid traders or systems with a portfolio of algorithms, can hold simultaneous positions of the same asset in opposite directions. This violates the NFA and FIFO compliance required by international brokers and can cause rejection of orders. Even if orders are accepted, holding long and short positions simultaneously increases risk, margin, and trading costs. It is always preferable to fully or partially close a position, rather than opening a new position in opposite direction.
Zorro's virtual hedging mechanism guarantees FIFO compliant closing of trades (oldest are closed first) and prevents positions in opposite directions, even with complex portfolio systems. This happens in a completely transparent way; the script needs no special code. The mechanism uses two layers of trades, phantom trades and pool trades. The pool trades hold the net amount of the phantom trades. The strategy script only handles the phantom trades, while the broker only receives orders for the pool trades. Pool trades are opened or closed when phantom trades open or close (but not necessarily in that order). Phantom trades can be open in both directions at the same time, but the resulting pool trades can be only open in one direction per asset, either short or long.









Systems with virtual hedging are always superior to systems with 'real hedging' that hold opposite positions. Aside from NFA and FIFO compliance, virtual hedging increases profit by lower transaction costs, and reduces risk because trades are usually closed earlier and are less exposed to price shocks or market crashes. For activating virtual hedging, only the Hedge variable (see below) needs to be set. All trades are then automatically entered in phantom mode. When the net amount - the difference of long and short open lots - changes, Zorro automatically opens or closes pool trades in a way that the market exposure is minimized. Example: several long positions are open with a total amount of 100 lots. Now a short trade of 40 lots is entered. The net amount is now 60 lots (100 long lots minus 40 short lots). Zorro closes the oldest long pool trades fully or partially until the sum of open positions is at 60 lots. If partial closing is not supported, the oldest long pool trades are fully closed until the remaining position is at or below 60 lots. If it's less than 60 lots, a new long pool trade is opened at the difference. In both cases the net amount ends up at exactly 60 lots.

Virtual hedging is used in test and trade mode only, not in training mode. The performance statistics (Long/Short/Total) are generated from the pool trades, not from the phantom trades. Only exception is NumPendingTotal, which is affected by pending phantom trades (pool trades are never pending). Phantom trades can also be manually entered for "equity curve trading"; those trades contribute to the Long/Short statistics, but do not trigger pool trades.

Virtual hedging affects the system performance parameters. Although the equity curves of a system with or without virtual hedging are relatively similar, the number of trades, the profit factor, the win rate, and the average trade duration can be very different. Although the performance with virtual hedging is better due to smaller trading costs and smaller risk, the win rate and profit factor can be lower because they are calculated from the pool trades. Thus, win rate and profit factor can have limited relevance for the overall performance of a system. Here's an example of the same grid trading system without and with virtual hedging:

EUR/CHF grid trader, real hedging, win rate ~95%, profit factor ~10, total profit ~$16000

EUR/CHF grid trader, same algorithm, virtual hedging, win rate ~65%, profit factor ~3, total profit ~$16500

Hedging is controlled by the following variable:


Hedging behavior; determines how simultaneous long and short positions with the same asset are handled.


0 = no hedging; automatically close opposite positions with the same asset when a new position is opened (default for NFA accounts).
1 = hedging across algos; automatically close opposite positions with the same algo when a new position is opened (default for unspecified accounts).
2 = full hedging; long and short positions can be open at the same time.
4 = virtual hedging without partial closing; enter long and short positions simultaneously, but send only the net amount to the broker.
5 = virtual hedging with partial closing; open positions are partially closed to match the net amount.





  Hedge = 5;  // virtual hedging in trade mode
  Hedge = 2;  // full hedging in test mode

See also:

NFA, enterLong/Short, LotsPool, Phantom trades


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