Last Updated on 20 April, 2023 by Samuelsson
Hedging is a risk management strategy that is used to minimize the potential loss from an adverse move in an investment. In trading, hedging strategies involve taking an offsetting position in a related security in order to reduce the potential loss from an adverse move in the original investment. Hedging can be a powerful tool for managing risk, but it is important to understand the costs and potential limitations associated with these strategies.
One common hedging strategy is using options. Options are contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a specific date. Call options give the holder the right to buy an underlying asset at a specific price, while put options give the holder the right to sell an underlying asset at a specific price. For example, if a trader owns a stock and is worried about a potential decline in its value, they could purchase a put option on the stock as a hedge. If the value of the stock does decline, the trader can exercise the option to sell the stock at the higher price, minimizing their loss.
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Another common hedging strategy is using futures. Futures are contracts that obligate the buyer to purchase an underlying asset at a specific price on a specific date in the future. Futures can be used to hedge against price movements in the underlying asset. For example, if a trader is worried about a potential increase in the price of a commodity, they could enter into a short futures contract on the commodity. If the price of the commodity does increase, the trader can offset their loss by purchasing the commodity at the lower price specified in the futures contract.
Short selling is another strategy that can be used for hedging. Short selling is the process of borrowing shares of a stock and selling them in the market, with the expectation that the stock’s price will decline. If the price does decline, the trader can purchase the shares back at the lower price and return them to the lender, making a profit. Short selling can be used as a hedge against a potential decline in the value of a stock that a trader owns.
However, there are costs and potential limitations associated with hedging strategies. The costs of using options and futures can include option premiums and bid-ask spreads. Short selling also comes with potential costs such as margin and interest on the borrowed shares. Additionally, it can be difficult to predict market movements, which can make it challenging to effectively use hedging strategies.
In conclusion, hedging strategies can be a powerful tool for managing risk in trading. However, it is important to understand the costs and potential limitations associated with these strategies before implementing them. Hedging strategies include using options, futures, and short selling. These strategies can be used to minimize the risk of loss in investments. Overall, Hedging is a crucial part of risk management in trading and should be taken into consideration by every trader.
Hedging trading strategies – do they work? Backtest and example
Let’s go on to look at several hedging trading strategies. As mentioned earlier in the article, there are many ways to hedge. We’ll go through some of the most common hedging trading strategies:
Hedging trading strategy: Covered calls
When you buy a call option you have the right to buy the stock at a certain level (strike) at a specific time (expiration). However, if you instead sell a call, you act as an insurance agent and are obliged to sell to the owner. That is risky because a stock can theoretically rise unlimited.
But if you own the underlying stock you write calls on, you are somewhat hedged. Thus, it works as a partial hedge.
Assume you own 100 MSFT. You can hedge this position partially if you sell one call. If MSFT trades at 250, you can sell calls with strike 275 6 months into the future (the expiration date). If you get (for example) 5 USD per call, you are thus lowering your purchase price by 5 USD. The option premium you receive for writing a call is yours to keep. The downside is, of course, that you are obliged to sell MSFT if the price goes above the strike of 275.
Covered calls are just a partial hedge. Is this a good strategy? We looked at covered calls writing in a separate article and looked at empirical results:
Hedging trading strategy: Tail risk hedging strategies
Nassim Nicholas Taleb got famous for his theories about black swans and tail risk.
If you want to hedge against tail risk, there are several ways to do that. We list the most obvious ones (put options, futures, and the Barbell Strategy):
Hedging trading strategy: Put options
The most obvious tail risk hedge is put options. If you have a broad stock portfolio you can simply buy put options on the S&P 500 and you’ll be mostly covered. The most likely option is to buy deep out-of-the-money options because they have the lowest premium but also the potential to rise in value if the markets head south fast.
Put hedging costs money and most options expire worthless, thus, you must expect worse performance if you add puts as a hedge. How much? The table below gives you an idea of the potential cost:
We have covered tail risk hedging in detail in a separate article:
Hedging trading strategy: Short futures
Instead of using put options, you can also short S&P 500 futures. However, futures don’t offer you the option of choosing different strike prices and thus, we believe options offer more flexibility.
Hedging trading strategy: Nassim Taleb – Barbell Strategy
To counter tail risk Nassim Taleb looked at another idea of constructing an antifragile portfolio: the Barbell Strategy.
The barbell refers to the barbell that weightlifters and bodybuilders use (Taleb is an avid weightlifter). The reason for the barbell analogy is that your assets and strategies should be binary from each other. While one side has “low-risk assets”, the other should contain “high-risk assets and strategies”. No middle ground!
The Barbell Strategy is best illustrated in a chart:
We are fans of Taleb’s and have written a long and detailed article about both his thinking about the Barbell Strategy:
Hedging trading strategy: Pairs trading
When we started our prop trading strategy careers, we did pairs trading. Why?
At the time (2001), competition was low and the movement was faster due to NYSE’s specialist system. Because the specialist used to “sweep” the order book to fill market orders, we frequently got significant price improvements for our limit orders and thus bigger profit potential. When we were filled either long or short in one leg of the pair, we rushed to hedge our position by taking the opposite position in a “similar” stock.
The main idea of pairs trading is to hedge both long and short. It’s far from a bulletproof strategy, but it worked nicely two decades back, but we believe it’s not as good anymore.
Please click here If you’d like to see a recent backtest of a pairs trading strategy (including statistics and historical performance).
Hedging trading strategy: Long-short equity strategy
A somewhat similar strategy to the pairs trading strategy is the long-short equity strategy. It’s a hedging strategy whereby a trader takes long positions in stocks that he or she assumes will rise and, at the same time, takes short positions that are expected to perform weaker. It’s the difference between the two positions that will eventually determine the profits and losses. The strategy is more or less the same as a pairs trading strategy.
Practically everyone who does hedging strategies via long-short equity strategies uses quantitative analysis. The innovator for this approach was Edward Thorp – the father of quantitative investing. He is famous for his ability to identify inefficient areas of the market and figure out ways to take advantage of mispricing.
Ed Thorp is also famous for being the one who beat the dealer at the Blackjack table, something he covered in his book called Beat The Dealer.
Summary
In conclusion, hedging strategies can be a powerful tool for managing risk in trading. However, it is important to understand the costs and potential limitations associated with these strategies before implementing them. Hedging strategies include using options, futures, and short selling. These strategies can be used to minimize the risk of loss in investments. Overall, Hedging is a crucial part of risk management in trading and should be taken into consideration by every trader.
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