Last Updated on June 24, 2020
How to use hedging as a trading strategy? We use it to take on specific risks. There are 2 ways. 1) Asset-hedge: This means to hedge it with another asset. 2) Time-hedge: This means to limit the time we hold our trade.
The common perception of hedging is that is a defensive move, that it protects you but require you to give up returns.
However, hedging is very much an offensive and important part of your trading strategy.
Why do we need hedging in our trading strategy
We need hedging because we want to take on target risks. To do that, we need to remove unwanted risks.
To trade is to take a risk in exchange for a potential return.
However, we do not want to take indiscriminate risks.
Let’s say we believe Stock X has better technology than its competitors. We want to make a long bet on its tech.
In this case, we want to take a risk on Stock X’s tech prowess.
But Stock X is more than just its tech, it includes operations, management, marketing, stock market influence and other factors. If we long Stock X, we will essentially be taking a bet on those other factors too.
The solution? Hedge away the unwanted factors (i.e. hedge away unwanted risk)
We find a stock that is similar to Stock X in every way except its tech. Let’s call this Stock Y.
And we short Stock Y.
The final trade is to long Stock X and short Stock Y. To put this in math form:
Stock X – Stock Y = (A+B+C) – (A+B-D) = C – D
Where A, B, C, D are factors and C and D represent the tech of Stocks X and Y respectively.
Now, you’re left with C-D, which is the difference between the tech ability of Stock X and Y.
This is the targeted risk we want.
Here are the common unwanted risks
- Market risk
- Volatility risk
- Interest rate risk
- Asset class-specific risk
- Industry-specific risk
- Country risk
As mentioned, there are 2 types of hedging, let’s talk about asset-hedging first.
What is asset-hedging
Asset-hedging refers to hedging your trade with another asset in order to target specific risks and exposure.
The above example with Stock X and Y is an example of asset-hedging.
By removing unwanted risks using other assets, we create a tradeable price behaviour in the resulting combined assets. This combined assets consists of your initial assets plus all other assets used in the hedging process.
We are going to call this combined assets a synthetic asset.
A tradeable price behaviour is a price behaviour that is predictable and offers opportunities.
The most common tradeable price behaviours are ranging or trending behavior. Here, we are saying that the synthetic asset is ranging or trending, not the individual assets.
Example – Ranging Synthetic Asset
Here we have Stock A. Stock A does whatever it wants. It is difficult to trade Stock A.
Here we have Stock B. Similarly, Stock B does whatever it wants. It is difficult to trade Stock B.
But if we combine Stock A and Stock B, we will notice something interesting.
Now we see that Stock A and Stock B move similarly.
Let’s see what the synthetic asset of “long 1 unit of Stock A and short 1 unit of Stock B” will look like.
We will represent this synthetic asset this way: 1*Stock A – 1*Stock B. The minus sign represents a short.
This is a ranging behaviour, in other words, it mean reverts around a certain level.
I know the chart doesn’t look that much like a ranging asset but that is due to my poor artistic skills.
Another reason is that a synthetic asset of just 2 assets usually don’t range too well, you usually need at least 3 assets.
This is what a synthetic asset of (Asset X – 2*Asset Y + Asset Z) might look like.
Synthetic assets could become even larger. Eg. 1*A – 5*B + 10*C – 10*D + 5*E – 1*F.
I’ve traded synthetic assets that consisted of up to 7 different assets. Generally, the larger the number of assets, the more stable the price behavior (i.e. more immune to external shocks) and the more profit opportunities there are.
However, increasing the number of assets will make it more difficult to execute the trade as we need to enter at precise prices for each asset.
Thus, it is important to balance the number of assets with the execution abilities of your algorithms or traders.
Other tradeable price behaviours
Tradeable price behaviours could include other more complex behaviours in the form of “if X happens, Y price behaviour should happen”.
For instance, in our first example on the tech stocks, the synthetic asset is (Stock X – Stock Y).
This could result in a tradeable price behaviour as such “If number of tech forums queries on Stock X is more than that of Stock Y, (Stock X – Stock Y) should rise”.
To visualise this, plot 2 datasets:
- Number of Stock X forum queries – Number of Stock Y forum queries
- Price of Stock X – Price of Stock Y
Then you can do a leading-lagging analysis to see if the first dataset leads the second. Though if it works, you can usually eye-ball it.
Non-traditional asset hedging
The markets are sophisticated. There are more opportunities in non-obvious places.
We need not hedge our trades using regular assets. We can hedge it using derivatives, customised financial products/deals, insurance products, betting sites and prediction markets etc.
What is time-hedging
Time-hedging refers to staying in your trade for only the time required to capture the targeted risk.
This means we do not hold the trade longer than necessary.
Time-hedging is suitable for the following scenarios:
- When the risk you are targeting happens during a clear time period
- When you can’t asset-hedge because there are no suitable assets to hedge against
- When you can’t or don’t want to asset-hedge because the asset-hedging costs are too high
- When you can’t or don’t want to asset-hedge because you can enter the other assets at a good price
- When there are too many external factors moving your asset that it is too difficult to asset-hedge (ahem Forex ahem)
Examples of time-hedging
- If we are trading stocks earnings, enter the trade before the earnings announcement and exit immediately after.
- If you are trading a seasonal pattern, such as there is buying pressure when Asia opens and selling pressure when US opens, enter and exit the trade within the day.
- If you are trading the futures rollover, only run your trades for a week every 3 months (and if the week has major events such as Brexit, skip that week of trading).
This way, we reduce the amount of unwanted risks that we are exposed to.
Is there such a thing as the perfect hedge in trading? In most cases, you will not find a perfect hedge. Eventually, you will need to take some unwanted risks. Your aim should be to minimise, not eliminate, unwanted risks.
What other names is asset-hedging known as? Relative value trading, cointegration trading, pair trading, statistical arbitrage, hard arbitrage, calendar spreads etc.