{"id":425,"date":"2019-10-31T15:46:13","date_gmt":"2019-10-31T15:46:13","guid":{"rendered":"http:\/\/algotrading101.com\/learn\/?p=425"},"modified":"2022-07-16T18:36:55","modified_gmt":"2022-07-16T18:36:55","slug":"how-to-use-hedging-as-a-trading-strategy","status":"publish","type":"post","link":"https:\/\/algotrading101.com\/learn\/how-to-use-hedging-as-a-trading-strategy\/","title":{"rendered":"How to use Hedging as a Trading Strategy"},"content":{"rendered":"
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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. <\/strong><\/p>\n\n\n\n

The common perception of hedging is that is a defensive move, that it protects you but require you to give up returns. <\/p>\n\n\n\n

However, hedging is very much an offensive and important part of your trading strategy.<\/p>\n\n\n\n

Why do we need hedging in our trading strategy<\/strong><\/h2>\n\n\n\n

We need hedging because we want to take on target risks. To do that, we need to remove unwanted risks.<\/p>\n\n\n\n

To trade is to take a risk in exchange for a potential return. <\/p>\n\n\n\n

However, we do not want to take indiscriminate risks.<\/p>\n\n\n\n

Example<\/strong><\/p>\n\n\n\n

Let’s say we believe Stock X has better technology than its competitors. We want to make a long bet on its tech.<\/p>\n\n\n\n

In this case, we want to take a risk on Stock X’s tech prowess.<\/p>\n\n\n\n

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.<\/p>\n\n\n\n

The solution? Hedge away the unwanted factors (i.e. hedge away unwanted risk)<\/em><\/p>\n\n\n\n

We find a stock that is similar to Stock X in every way except its tech. Let’s call this Stock Y.<\/p>\n\n\n\n

And we short Stock Y.<\/p>\n\n\n\n

The final trade is to long Stock X and short Stock Y. To put this in math form:<\/p>\n\n\n\n

Stock X – Stock Y = (A+B+C) – (A+B-D) = C – D<\/p>\n\n\n\n

Where A, B, C, D are factors and C and D represent the tech of Stocks X and Y respectively.<\/p>\n\n\n\n

Now, you’re left with C-D, which is the difference between the tech ability of Stock X and Y. <\/p>\n\n\n\n

This is the targeted risk we want.<\/p>\n\n\n\n

Here are the common unwanted risks<\/strong><\/p>\n\n\n\n

  • Market risk<\/li>
  • Volatility risk<\/li>
  • Interest rate risk<\/li>
  • Asset class-specific risk<\/li>
  • Industry-specific risk<\/li>
  • Country risk <\/li><\/ul>\n\n\n\n

    As mentioned, there are 2 types of hedging, let’s talk about asset-hedging first.<\/p>\n\n\n\n

    What is asset-hedging<\/h3>\n\n\n\n

    Asset-hedging refers to hedging your trade with another asset in order to target specific risks and exposure.<\/p>\n\n\n\n

    The above example with Stock X and Y is an example of asset-hedging.<\/p>\n\n\n\n

    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.<\/p>\n\n\n\n

    We are going to call this combined assets a synthetic asset. <\/p>\n\n\n\n

    Synthetic asset<\/strong><\/p>\n\n\n\n

    A tradeable price behaviour is a price behaviour that is predictable and offers opportunities. <\/p>\n\n\n\n

    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.<\/p>\n\n\n\n

    Example – Ranging Synthetic Asset<\/em><\/p>\n\n\n

    \n
    \"\"<\/figure><\/div>\n\n\n

    Here we have Stock A. Stock A does whatever it wants. It is difficult to trade Stock A.<\/p>\n\n\n

    \n
    \"\"<\/figure><\/div>\n\n\n

    Here we have Stock B. Similarly, Stock B does whatever it wants. It is difficult to trade Stock B. <\/p>\n\n\n\n

    But if we combine Stock A and Stock B, we will notice something interesting.<\/p>\n\n\n

    \n
    \"\"<\/figure><\/div>\n\n\n

    Now we see that Stock A and Stock B move similarly.<\/p>\n\n\n\n

    Let’s see what the synthetic asset of “long 1 unit of Stock A and short 1 unit of Stock B” will look like. <\/p>\n\n\n\n

    We will represent this synthetic asset this way: 1*Stock A – 1*Stock B. The minus sign represents a short.<\/p>\n\n\n

    \n
    \"\"<\/figure><\/div>\n\n\n

    This is a ranging behaviour, in other words, it mean reverts around a certain level.<\/p>\n\n\n\n

    I know the chart doesn’t look that much like a ranging asset but that is due to my poor artistic skills.<\/p>\n\n\n\n

    Another reason is that a synthetic asset of just 2 assets usually don’t range too well, you usually need at least 3 assets.<\/p>\n\n\n\n

    \"\"<\/figure>\n\n\n\n

    This is what a synthetic asset of (Asset X – 2*Asset Y + Asset Z) might look like.<\/p>\n\n\n\n

    Synthetic assets could become even larger. Eg. 1*A – 5*B + 10*C – 10*D + 5*E – 1*F.<\/p>\n\n\n\n

    I\u2019ve 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.<\/p>\n\n\n\n

    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.<\/p>\n\n\n\n

    Thus, it is important to balance the number of assets with the execution abilities of your algorithms or traders.<\/p>\n\n\n\n

    Other tradeable price behaviours<\/em><\/p>\n\n\n\n

    Tradeable price behaviours could include other more complex behaviours in the form of “if X happens, Y price behaviour should happen”.<\/p>\n\n\n\n

    For instance, in our first example on the tech stocks, the synthetic asset is (Stock X – Stock Y). <\/p>\n\n\n\n

    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”.<\/p>\n\n\n\n

    To visualise this, plot 2 datasets: <\/p>\n\n\n\n

    • Number of Stock X forum queries – Number of Stock Y forum queries<\/li>
    • Price of Stock X – Price of Stock Y<\/li><\/ul>\n\n\n\n

      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.<\/p>\n\n\n\n

      Non-traditional asset hedging<\/strong><\/p>\n\n\n\n

      The markets are sophisticated. There are more opportunities in non-obvious places.<\/p>\n\n\n\n

      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.<\/p>\n\n\n\n

      What is time-hedging<\/h3>\n\n\n\n

      Time-hedging refers to staying in your trade for only the time required to capture the targeted risk.<\/p>\n\n\n\n

      This means we do not hold the trade longer than necessary.<\/p>\n\n\n\n

      Time-hedging is suitable for the following scenarios:<\/strong><\/p>\n\n\n\n

      • When the risk you are targeting happens during a clear time period<\/li>
      • When you can’t asset-hedge because there are no suitable assets to hedge against<\/li>
      • When you can’t or don’t want to asset-hedge because the asset-hedging costs are too high<\/li>
      • When you can’t or don’t want to asset-hedge because you can enter the other assets at a good price<\/li>
      • When there are too many external factors moving your asset that it is too difficult to asset-hedge (ahem Forex ahem)<\/li><\/ul>\n\n\n\n

        Examples of time-hedging<\/strong><\/p>\n\n\n\n

        • If we are trading stocks earnings, enter the trade before the earnings announcement and exit immediately after.<\/li>
        • 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.<\/li>
        • 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).<\/li><\/ul>\n\n\n\n

          This way, we reduce the amount of unwanted risks that we are exposed to.<\/p>\n\n\n\n

          Related Questions<\/h2>\n\n\n\n

          Is there such a thing as the perfect hedge in trading? <\/strong>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.<\/p>\n\n\n\n

          What other names is asset-hedging known as?<\/strong> Relative value trading, cointegration trading, pair trading, statistical arbitrage, hard arbitrage, calendar spreads etc.<\/p>\n","protected":false},"excerpt":{"rendered":"

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          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 […]<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"closed","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_lmt_disableupdate":"","_lmt_disable":"","_monsterinsights_skip_tracking":false,"_monsterinsights_sitenote_active":false,"_monsterinsights_sitenote_note":"","_monsterinsights_sitenote_category":0},"categories":[2],"tags":[],"yoast_head":"\nHow to use Hedging as a Trading Strategy - AlgoTrading101 Blog<\/title>\n<meta name=\"description\" content=\"We use it to take on specific risks. There is 2 ways. 1) Asset-hedge. This means to hedge it with another asset. 2) Time-hedge. 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