The Best Methods of Hedging

Discussion in 'Risk Management' started by schizo, May 28, 2010.

  1. schizo


    I would like to get a good discussion on a variety of ways to hedge your bet. I personally do not hedge my positions but I believe this is a critical element of trading that should not be overlooked. Well, at least you'll want to keep it on the back burner.

    So far, I know there's a couple ways to hedge effectively:
    1. Options
    2. Pair trade: ES/YM or ES/SPY
    Any other possibilities? Also I would like to know other intricacies involved in hedging, such as what is the optimal ratio one should hedge in relation to the underlying.
  2. When I am long equities, I will generally hedge with options. This is particularly true if I want to hedge in my position for a good long time.

    However, sometimes when Im long a basket of equities, if there has been a major run up or some major negative news, I will hedge with an appropriate number of ES contracts. I will generally only hold this hedge until i think the weakness has subsided, usually very short term.

    The benefit of the options approach is the hedge cost is fixed, and you can "set it and forget it" mostly. You can also defray some of the cost with short calls if you like.

    The benefit of using ES contracts for short term hedges is you can get yourself essentially "market neutral" on a very short term basis if you aren't feeling confident about market direction or if you want to temporarily lock in a price level or profits.

    For example, Wednesday morning was a great time to hedge in your position with ES contracts after a huge overnight run up. I failed to do this because i was playing golf, and by the time i was done the market had dropped 30 points.

    Anyway, those are my two cents.
  3. traderhf


    I don't have much to add, apart from what HuggieBear has already said. I primarily trade FX and my hedging scheme is pretty simple. Since, mostly I have pure delta1 positions, I have three alternatives if I want to hedge:

    1. Get out of the outright position and look to enter again at a better price or when market conditions become stable.

    2. Hedge current position through some cross or some correlated currency. Why one would do this, instead of simply closing the primary position? The answer is that if it is a very short term trade and I am highly leveraged, then putting in another position in a correlated currency reduces my leverage (thus reducing the possibility that IB will auto-liquidate). Secondly, sometimes movements in the hedge currency could be much faster and larger compared to main position. So, net net your hedge pnl is larger than your loss on your primary position. Once, I have determined that hedge has worked appropriately, I can unwind the hedge and be left with my primary position, which will eventually turn out OK if my view was correct. An example would be I would hedge long euro +aud against dollar position with a long yen position.

    3. If I am playing risk trade and trying to hedge out the 'risk', sometimes I use ES as a hedge against my ccy portfolio.

    I guess conversely, people playing stocks and ES/CL primarily might want to learn a bit about ccys, as ccys can be a good hedge in times of distress...just my opinion!
  4. Rather than hedge, I trade low correlated strategies, including several long and one short. The short strategy is not strictly a hedge but when combined with the long portfolio's it generally reduces portfolio volatility and drawdown.
  5. My strategy is both short and long. I'm only sim / paper trading right now. But someone on ET suggested hedging with VIX (symbol VXX) and it looks good so far.
  6. I suggest you look into that yourself first. Apparently VXX underperforms $VIX pretty significantly:

    A static allocation to VXX since it's inception would have done very poorly as a hedge. VXN has done better and may have provided some risk reduction at a cost of lower returns.
  7. schizo


    First of all, what is the correlation between the VIX and, say, S&P 500 (or ES), and what is the optimal ratio you would use to hedge the underlying position?

    Logically speaking, hedging doesn't make much sense to me. For example, suppose ES hit the HOD at 1100. You assume there will be a slight pullback down to 1095 before possibly resuming its uptrend. If it were me, I would either close my long or simply flip short with a tight stop. But I guess it could also work if you hedged 100% of your current position.

    But here's the twist. If you hedged 100%, you're basically flat. If you hedged 50% and the underlying does in fact pull back, you're losing money. What's worse, you never know for certain that ES will reverse and resume its uptrend at 1095. How would you then deal with such a problem?
  8. Historically, it might not have worked out so well. Recently, it has worked out great. Although it might be better to explore other hedges. VIX futures directly rather than VXX. Put options on the S&P 500. Other? Specifically I'm trying to protect against major losses (when indexes move 3% or more in either direction).

    "The [VIX] index has a positive return 95% of the time that the S&P 500 has a loss of more than 1%"

    Hedge is to reduce overall volatility/beta/risk. Being both long and short in different baskets/sectors (my strategy) helps, but only when the trends are certain. When trend is uncertain (volatility is high) VIX is also high. So VIX is a good fit that way. Whether there would be a better fit, or just go to cash during periods of high volatility, is for future consideration.
  9. Basically you want to isolate the factors you think you have an edge in, and remove any exposure to factors you have no view on. So let's say you think the oil service stocks are undervalued based on their price to book compared to historical norms, and the current BP selloff - you want to bet on that, but you don't want to take a view on the general valuation of stocks, or on oil prices. You would go long non-affected oil services stocks, then short either the S&P, or a commodity index, or (best) a mix of the two.

    How to determine ratios? The ideal hedge ratio is simply the one which minimizes your risk relative to reward over all timeframes you will be exposed to. IMO this is more art than science. You have to look at the economic and market characteristics of both your main play and the various potential hedges available, then select the one that will track as well as possible the factors you want to be hedged against, whilst not tracking at all your exposures that you want to have on. You need to do scenario analysis to estimate how the hedge and the main asset will move relative to each other. This takes market experience and judgement.

    A common mistake is to use the stock or sector's beta to determine the hedge ratio. The problem is that beta is often a poor predictor of the ratio performance of your two legs over the intended timeframe. Beta is measured over a specific period and thus is only useful if i) you intend to trade on that timeframe - not shorter, or longer-term ii) past beta is accurate about future beta. Beta also requires dynamic hedging to maintain hedge ratios, which makes you short gamma and thus is a losing bet in volatile environments, or situations with high transactions costs/taxes. Never go short gamma unless you are being paid absurd amounts to do so (even then it's not generally a good idea IMO). Beta ratio hedging is disastrous when beta is high and then the stock doesn't perform as expected. Imagine hedging a stock with a beta of 4, and then the S&P rises 25% and your stock is flat - congrats you just went bust!

    A great example of a trader not understanding how to hedge, and misusing beta, was a blogger who in late 08/early 09 was looking at the gold/platinum spread. Normally platinum trades at a premium to gold, at least it has for about the last decade. This guy correctly reasoned that, with platinum having gone below the price of gold, this was just due to panic liquidation, and that once the panic passed, the value relationship would reassert itself and platinum would go back to a substantial premium. However, he then screwed up by trying to go quant, taking on board the typical quant lack of understanding of market fundamentals in favour of naive sophomore statistical "analysis". Simple mental arithmetic would tell you that if platinum at 50% more than gold was "normal" pricing, then buying equal amounts of platinum and shorting equal amounts of gold when platinum was at parity with gold, would result in a 50% return on capital if the spread went from parity back to 50% platinum premium. And that this 50% return would happen regardless of what happened to gold or platinum prices in absolute terms. As long as the spread returned to 50% premium, you'd make 50% - whether gold fell to $400 or rose to $2000. Yet this guy used beta to calculate his hedge - completely moronic, because beta just measures the difference in typical daily move of the outright, but he was speculating on a multi-month/year spread move. Because platinum had twice the daily vol, he did a spread on a ratio - he went long 1 platinum and short 1 gold. Platinum contracts are half the size of gold, so effectively he was 100% short gold and 50% long platinum. This gave him enormous risk - if gold and platinum both doubled but the spread stayed unchanged at parity, he would lose 50% of his capital. If gold doubled and the spread went back to 50% platinum premium, he would not make a dime. He unintentionally had on an effective short position.

    The lesson is, use scenario analysis to judge hedge ratios, NOT beta or other quantitative/statistical measures in isolation. You have to understand what stats are measuring before you can use them properly.