How to accurately arbitrage and hedge risks in a linked trading strategy?

In this market, choosing the right trading strategy is crucial for traders to make profits. Many traders are still looking for strategies that suit them, so today EagleTrader will introduce a unique and effective trading strategy – a linkage trading strategy (also known as “neutral hedging”. This strategy takes advantage of the correlation between currency pairs, hedges the risk by opening positions at the same time with varying positions, and using the currency’s overnight interest differences to earn interest spreads. So how should this strategy be used?

What is a connected trading strategy

Connective trading strategies are a strategy that uses their synchronization or reverse volatility to make trading decisions based on the price correlation between two or more currency pairs. For example, trade using currency pair combinations such as EUR/USD and USD/CHF, GBP/USD and USD/CHF, AUD/USD and NZD/USD. The core of this strategy is to observe the fluctuations of one currency pair, predict the trend of another related currency pair, and use this relationship to perform arbitrage or risk hedging.

Principles of application of strategy

Positive correlation and negative correlation

Positive correlation: When the price trends of two currency pairs fluctuate in the same direction, we call them positive correlation. For example, EUR/USD and GBP/USD usually show a positive correlation, that is, when EUR/USD rises, GBP/USD tends to rise.

Negative correlation: When the price trends of two currency pairs show inverse fluctuations, we call them negative correlations. For example, EUR/USD and USD/CHF usually show negative correlations, i.e. when EUR/USD rises, USD/CHF tends to fall.

arbitrage and hedging

Arbitrage: Use the price difference between two positive or negative correlation currency pairs to buy low-priced currency pairs and sell high-priced currency pairs to obtain the difference profit.

Hedging: While holding a currency pair, reduce overall risk by trading negatively related currency pairs. For example, when holding EUR/USD longs, USD/CHF shorts can be traded to hedge risks.

Applicable scenarios

This strategy is suitable for periods where market volatility is small and currency pairs are highly correlated. Through neutral hedging, traders can reduce the risks brought by market volatility to a certain extent while obtaining stable interest income.

How to apply strategy

1. Select currency pairs: Select currency pairs with correlation, such as EUR/USD and USD/CHF.

2. Determine the position size: Determine the unequal position size based on the exchange rate relationship of the currency pair. For example, if EUR/USD=1.06 and USD/CHF=1.00, you can open 1.0 lots of EUR/USD and 1.06 lots of USD/CHF to offset the risk.

3. Use overnight interest differences: Earn interest spreads by selecting the overnight interest differences between different currency pairs. For example, if the overnight interest on EUR/USD pays is US$1.90 and the overnight interest on USD/CHF pays is US$0, you can receive daily interest income of 0.96×1.90=1.82 per day.

Precautions for strategy

Relevance Assessment

Relevance is not absolute, so the correlation between currency pairs needs to be regularly evaluated and adjusted. Historical data and technical indicators can be used to assist in evaluating changes in correlation.

Fund Management

Fund management is a crucial part of the linked trading strategy. Funds need to be allocated reasonably to avoid excessive trading and heavy positions.

Risk Control

Set a reasonable stop loss point to control potential losses. Avoid trading when market uncertainty is high to reduce risks.

Connective trading strategies are effective when the market fluctuates less and the currency pair is highly correlated, but when the currency pair diverges, the risk is greater. Therefore, in practical applications, traders need to flexibly use this strategy based on their own risk preferences and trading experience, and constantly learn and practice to improve their trading level.