Quote from schizo:
I would like to get a good discussion on a variety of ways to hedge your bet. I personally do not hedge my positions but I believe this is a critical element of trading that should not be overlooked. Well, at least you'll want to keep it on the back burner.
So far, I know there's a couple ways to hedge effectively:
- Options
- Pair trade: ES/YM or ES/SPY
Any other possibilities? Also I would like to know other intricacies involved in hedging, such as what is the optimal ratio one should hedge in relation to the underlying.
Basically you want to isolate the factors you think you have an edge in, and remove any exposure to factors you have no view on. So let's say you think the oil service stocks are undervalued based on their price to book compared to historical norms, and the current BP selloff - you want to bet on that, but you don't want to take a view on the general valuation of stocks, or on oil prices. You would go long non-affected oil services stocks, then short either the S&P, or a commodity index, or (best) a mix of the two.
How to determine ratios? The ideal hedge ratio is simply the one which minimizes your risk relative to reward over all timeframes you will be exposed to. IMO this is more art than science. You have to look at the economic and market characteristics of both your main play and the various potential hedges available, then select the one that will track as well as possible the factors you want to be hedged against, whilst not tracking at all your exposures that you want to have on. You need to do scenario analysis to estimate how the hedge and the main asset will move relative to each other. This takes market experience and judgement.
A common mistake is to use the stock or sector's beta to determine the hedge ratio. The problem is that beta is often a poor predictor of the ratio performance of your two legs over the intended timeframe. Beta is measured over a specific period and thus is only useful if i) you intend to trade on that timeframe - not shorter, or longer-term ii) past beta is accurate about future beta. Beta also requires dynamic hedging to maintain hedge ratios, which makes you short gamma and thus is a losing bet in volatile environments, or situations with high transactions costs/taxes. Never go short gamma unless you are being paid absurd amounts to do so (even then it's not generally a good idea IMO). Beta ratio hedging is disastrous when beta is high and then the stock doesn't perform as expected. Imagine hedging a stock with a beta of 4, and then the S&P rises 25% and your stock is flat - congrats you just went bust!
A great example of a trader not understanding how to hedge, and misusing beta, was a blogger who in late 08/early 09 was looking at the gold/platinum spread. Normally platinum trades at a premium to gold, at least it has for about the last decade. This guy correctly reasoned that, with platinum having gone below the price of gold, this was just due to panic liquidation, and that once the panic passed, the value relationship would reassert itself and platinum would go back to a substantial premium. However, he then screwed up by trying to go quant, taking on board the typical quant lack of understanding of market fundamentals in favour of naive sophomore statistical "analysis". Simple mental arithmetic would tell you that if platinum at 50% more than gold was "normal" pricing, then buying equal amounts of platinum and shorting equal amounts of gold when platinum was at parity with gold, would result in a 50% return on capital if the spread went from parity back to 50% platinum premium. And that this 50% return would happen regardless of what happened to gold or platinum prices in absolute terms. As long as the spread returned to 50% premium, you'd make 50% - whether gold fell to $400 or rose to $2000. Yet this guy used beta to calculate his hedge - completely moronic, because beta just measures the difference in typical daily move of the outright, but he was speculating on a multi-month/year spread move. Because platinum had twice the daily vol, he did a spread on a ratio - he went long 1 platinum and short 1 gold. Platinum contracts are half the size of gold, so effectively he was 100% short gold and 50% long platinum. This gave him enormous risk - if gold and platinum both doubled but the spread stayed unchanged at parity, he would lose 50% of his capital. If gold doubled and the spread went back to 50% platinum premium, he would not make a dime. He unintentionally had on an effective short position.
The lesson is, use scenario analysis to judge hedge ratios, NOT beta or other quantitative/statistical measures in isolation. You have to understand what stats are measuring before you can use them properly.
