Monday, July 16, 2012


Point Blank here---most "hedges" that are done by normal people are  inspired as a means of protection or out a sense of being responsible, when in fact they are the opposite.   It sounds so cool at your neighborhood BBQ...I placed a hedge on my long Cable you must be an expert.

In reality, placing a hedge exposes you to 2 large bets that may both lose.  And sometimes it just protects your ego from having to admit that you were wrong and close the trade.  Thus a hedge can be counterproductive.   Mostly hedging is "betting against yourself" and if you understand "intellectual capital or mental capital" in the trading game, betting against yourself as well as holding a losing position for too long can be very damaging to your weekly profitability curve.   It might take you a long time to get your mojo back.

There are a few cases where I see a hedge as justified-

Let's say you have long 100 call contracts of Apple and just say that they report earning after the close.   It is after the close and they report godawful earnings.    You can expect your calls to be crushed in value.   You can also expect the Nasdaq to drop significantly.   So the hedge is to sell the futures, sell /NQ.    Picking the amount to sell is then the question and the answer will depend on your call Delta and other Greeks.

Let say you have 10000 shares of various equities long into the weekend and you can't trade until Monday AM.    Greek Prime Minister spouts off on Sunday afternoon EST...take your Euro and shove it.   When you wake up on Monday you will be in a shit storm of selling and maybe at terrible prices, so you short 10 contracts /ES to try to counteract act obvious losses.  

So using futures to Hedge market moving events when the equities market is closed is an OK Hedge, but they don't always work out.  

Or lets you picked up some DVN calls, and they are thinly traded, meaning there just isn't that much open interest and daily volume, and also the spread between bid and ask is pretty large.  Now lets say some bad market news hits, like Bernanke gets on stage tomorrow and says "I am in league with the Devil", of course stocks will tank but your thinly traded calls may nearly evaporate in value, so to sell them would be like taking a massive loss in an illiquid market.  But you think your long term (October) calls are still a good bet and you don't want to sell into an abyss..  sell some ES futures (S&P 500) or maybe even sell /CL (Oil futures) since DVN is an energy stock.  At some point when the think the near term selling is done or overdone, then remove your hedge.    Again the tricky part, hedges don't always work out.

Or Marketsniper gives a good example of TK having a Boatload of positions, and rather than trying to close them all down (perhaps at the worst time), simple put on an opposite hedge.  Then you can address them at a time and rate of your choosing, or maybe just ride through a blip.  

I rarely have more than 4 to 7 positions, for me between watching the positions and watching the market "guts", the internals and other custom indicators I have developed, it just doesn't work for me to try to run more positions.   I would rather run fewer and bigger positions in more liquid issues.

And you don't have to use futures to hedge, you could use an equity index, or options.   But with futures you get a lot of bang for your buck and you can put them on after hours and on Sunday.

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Insightful and Useful Comment!