Why hedge, why not just buy a smaller position?

Discussion in 'Trading' started by IronFist, Nov 19, 2017.

  1. Except in cases where someone doesn't know the direction the market is going to go and is trading each side separately, I don't know how hedging provides an advantage.
  2. tomorton


    Me neither. It would be nice for a successful hedger, not a theoretical hedger, to demonstrate how this has helped them as a private retail trader.
  3. sle


    If your hedge is costless, the decision comes down to simply thinking that for the same variance I can take a bigger position in my alpha asset and thus make more money. In an real world, it's a decision where you are weighing the cost of the hedge against the expected reduction in variance.
    777 likes this.
  4. ironchef


    Market makers almost always hedge? Professional traders often hedge and harvest small returns, but with OPM they can achieve consistent, high probability of profits.

    As a retail mom and pop trader, I found hedging costly. There is no free lunch for me. Hedging reduce risks but also reduce returns.

    Any words of wisdom is greatly appreciated.
  5. sle


    I could see that. I guess in addition to the costs, hedging reduces capital efficiency.
    777 likes this.
  6. s0mmi


    This is a very common question to those who are new to trading or aren't profitable yet. All of my trainees ask this question and even I asked it before I started to learn spreads.

    The simple reason is this;

    Big investors, institutional traders, and everyone important are also hedging. They do not adjust cheap or expensive products based off just 1 product by itself, but by looking at related products to the side of it.

    But what does this mean on an execution basis?

    It means if you Buy the spread (A-B) (long A, short B) because you believe it's cheap, you are NOT saying that Product A should go up and product B should go down in absolute terms.

    What you are saying is that, given a certain asset move around the world, when it comes time for 'adjustment', the big guys will leave more bids in A (or hit market up) relative to B.

    Remember, at any time, there are certain assets moving and other assets sleeping. Sometimes, the Commodities (Base Metals or Energies) are firing off for a few hours. Another time, its the equities leading the world. Another time, bonds or currencies are moving. You can never pick which is going to happen, but all you can do is prepare yourself for potential future moves by putting on a spread (or double spread).

    In absolute terms:
    Your trade will approach your profit in a way such that A is stronger than B (and this can happen through multiple scenarios which you aren't in control of).

    This is in contrast of someone buying up A (in absolute terms) and then selling B (in absolute terms).

    Here's an example, If you are long the Treasury Tnote (TYA) and short the Bond (USA), I will promise you that there is less than 1% chance that someone will adjust the spread by bidding up the T-notes and selling down the Bond in one day, and just cracking both sides of the spread.

    The reason for this is because of the enormous amount of microwave network parasites, vultures, otherwise known as scum f@ggots, which are locked in at the exchange (Jump, Citadel Trading etc.). They have negotiated contracts with the exchange (like CME), they receive cheaper brokerage, faster connections, and they have statistically modelled every single of electronic trading since inception.

    When a player hits up in the Tnotes (TYA) you will immediately see them, like parasites, with-in 1 millisecond, bid the corresponding 2yr (TUA), 5yr (FVA), 10yr (TNA) and Ultra 30yr (ULA).

    As you know, markets are heavily correlated now and the correlations, on a small-level, are the highest they've ever been in the history of markets due to algorithms.

    Final Conclusion
    The reason why you hedge is because you essentially have more time to exit, more ways to exit, and more potential reasons that your trade will go onside. And of course, your variance of returns will be much lower.

    When you are trading a product Outright, you are playing a high-variance game. Will a buyer or a seller appear next? Who the f*ck knows?

    When you are trading a product via Spread, you are playing a lower-variance game. Will a buyer or seller appear next? If you believe the relationship is cheap, then the buyer will look at the global markets, and other global products, to decide whether or not they should be leaving Bids down the line in Product A (as it crashes, to soften the crash), OR should they be buying up A quicker than B (because the other global/related products are going up).

    The biggest, most profitable, and longest surviving traders I've ever met, heard or, or spoken to, have all been spreaders. Every single one of them. I've traded for 6.5 years now and I immediately saw success the day I started spreading when I knew nothing.

    The biggest outright traders I know, who are much rarer than you think, are very susceptible to streaky losses. They can have periods where their accounts are -400k and more, and they can go through many months where they aren't in tune with the market. The edge is razor thin. However, they can have monster up days.

    Of course, this is anecdotal evidence from the past 6.5 years I've been in the game.
  7. ironchef


    Let me provide some perspectives from a retail options trader who trade directional:

    1. It costs too much to hedge right from the get go. And once hedged, there is usually no profit, slippage and commission are just too onerous. So I do not no hedge at the initiation of a trade.

    2. But, if I get lucky and the trade becomes profitable, there are many ways I can hedge to preserve my profits. Invariably, they all cost me something, usually additional future gains. Mostly, I tried to do a delta hedge to soften the "directional" in my directional trade because I worry about "reversal".

    3. If I get into trouble and have a losing position, I can try to hedge and limit my losses, instead of using a stop loss and this allows some potential recovery. But again no free lunch, it locks in some losses.

    As a retail trader with limited analytical resources gut feel is often all I have to make decision.

  8. Surprise


    Hedging example :
    Long ES futures at 2580 .
    Long SPX 2520 put .

  9. Huh, you have all kinds of sophisticated resources , mostly for free. What you mean is limited analytical skill.
  10. Is there an advantage there?
    #10     Nov 20, 2017