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Hedging
Hedging is when you open a position that reduces risk in one or more other positions. For example, if you own (are long) 10 stocks and the market
as a whole is having a bad day/week then your entire portfolio of stocks will probably suffer a large combined loss
because 70% of stocks will follow the market. However, if you had 7 long positions
and
three short positions you are now net long just 4 positions. You could then hedge the
remaining long exposure with a risk reversal strategy that would cost
you very little and you would be completely hedged.
The first type of hedging that you should consider is pairs trading. If you can find a few stock to go short, then try to pair them up with
long trades in the same industry. For example, if you want to go short JC Penny then you might go long Macys. By hedging in a pairs trade you
have less risk of a failed hedge. If you went short JC Penny and long Caterpillar as your pairs trade then they could easily be so disconnected in their
outcomes that it offers little hedging protection. Short trades are usually harder to find that long trades so you should start
with the short trade. Try to avoid shorting stocks that
are already heavily shorted as these are at risk of a
big pop on any positive rumor.
A second strategy is to buy Put options against your net long positions (ones that are not part of a pairs trade). This will work but the Puts
will cost you money. If options are cheap (VIX is low) then buying Puts can be a good way to go since risk reversals are usually less attractive
when options are cheap. If options are expensive (VIX is above 17) then risk reversals are clearly the best way to go. When applying a risk-reversal
trade to protect a long position then it is called a "collar".
A collar consists of selling an out of the money Put and buying an out of the money
Call, both with the same expiration date. If you are long
500 shares of XYZ stock at a $50 cost and you want to hedge it then you would buy 5 Puts at the 47.50 strike price and sell 5 Calls at the 52.5 or
55.00 strike price. The 55.00 strike would be better if the stock is trending up strongly and there is no danger
of a decline in sight but you will get less money
from the sale, which will increase the cost of your hedge.
If XYZ stock drops down to 47.50 then you will stop your loss because the Put will rise in value just as fast as the stock loses value. If the stock
moves above your Call option then you will not be able to make any more money because the Call option will lose money just as fast as the stock gains
money. I prefer to leave a position unhedged for a day or two (with a stop loss) and either exit the trade if it is unprofitable or hedge it if it
is profitable. A hedged position does not require a stop loss because it is already fully protected. The hedge
should generally be removed at exactly the
same time as the stock trade. An exception would be that
you could wait a few hours to sell the Put element
of the trade if the stock is continuing to trend
down.
The sale of the Call option ios to reduce the cost of the Put option. In the above example you paid 1.25 for the Put, which is now a loss of 1.25 per share
for the trade. However, you received .85 for selling the Call options so your net cost is now down to .40 per share. You trade some of your potential
future gains for reduced risk. If the stock did rise to 52.50 then you would have made 2.50 - .40 per share on the trade. If you had not sold the Call
then you would need to make 51.25 just to break even (50.00 + 1.25 for the cost of the Puts). You can also sell a few additional Calls at a higher strike
price to raise an additional 10-15 cents per share to further lower the collar's cost. However, you need to close the whole thing out if you hit the
first profitable strike price (52.5) to prevent a loss
if it continues to go higher. Puts cost more than Calls for the same distance to the current stock price so
if you get the idea that you will just sell more calls until it pays for the Puts then you
will need to buy too many Calls and are increasing your risk too much. If you buy too many
Calls in an effort to pay for the Puts you will reverse
the direction of the trade (in this case become net
short).
Sometimes in very bullish markets it is tempting to not hedge, but this is dangerous. It would be better to do a partial hedge than no hedge at all.
People get excited in bullish markets (or bearish ones) and
sometimes want to reverse the hedging strategy to double the gain (or loss). This is called a
"Texas Hedge" (From Texas cattle ranchers who bought cattle futures contracts while already owning cattle, thereby doubling their risk exposure). A
Texas Hedge can also be a poorly constructed attempt at a Collar where risk is increased rather than decreased.
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