Why hedge, why not just buy a smaller position?

[ironchef]

Huh, you have all kinds of sophisticated resources , mostly for free. What you mean is limited analytical skill.

Yes, that too, I admit.

If you can find a free programs to predict future volatility etc. accurately, I appreciate you can share that with me.

Thanks you.

 

[ironchef]

Any play you make needs to turn out to have been correct for you to benefit... including offsetting hedges. That is... if you buy puts to hedge and the market/issue does not decline, the hedge "didn't work out" and cost you. All you got was some temporary peace of mind for the cost of the premium.

Holding a large cash position is also a hedge. But if the market goes up without you, your cash hedge "didn't work out" and hurt your results.

Exercising your stop is also a hedge.

IOW... hedges help your portfolio only when they work out. All the rest of the time they hurt you.... same as owning/shorting issues.

To make any real money in the markets you usually need to make a large, unhedged bet and be correct.

Totally agree. Thanks for the coaching.

As a fairly new retail option trader, that is what I found. As a result, I ended up making directional bets. Those spreads, butterflies, condors, ratios... requiring good understanding of multi-parameter behaviors, are just too complicated for me to understand let alone profit from them.

 

[bone]

Except in cases where someone doesn't know the direction the market is going to go and is trading each side separately, I don't know how hedging provides an advantage.

From my experience, sweeping generalist value statements are fraught with danger. I'm personally guilty of it but I try to be mindful of it.

But hedging with purpose as part of a core strategy makes all the sense in the world.

I've seen a number of traders over the years who nursed along a loser with a "hedge". In the pits we used to call this a "Texas Hedge" and it wasn't a compliment. Over the long run if you are trading outrights as your original intent and strategy from my experience it is almost always better to just take your lumps and move on the next opportunity rather than to belatedly nurse along your stinker with a "hedge". I don't call this "hedging" - I call it an excuse for bad behavior. In that context I agree with your contention most wholeheartedly.

But as you alluded to in your OP, and for the purposes of a general explanation to other Members, there are perfectly good reasons to hedge as a core strategy.

In the 1990's I traded commercially for one of the biggest electric utilities in the country. We were both producers (power) and users (fuels) on a large industrial scale. Hedging was the reason for our trading desk's existence, and the value added price improvement we personally added was the basis for our bonus structure.

There are a number of options vol traders who choose to use strangles and straddles in order to help minimize the effects of theta decay. In fact, hedging is an integral part of many options strategies.

Just about any arbitrage and basis trading strategy that I'm aware of involves hedging.

There are countless relative value hedged equity portfolio strategies.

And near and dear to my heart, there is the inter and intra market futures spread trade.

All of these examples I cite above have a common denominator - the hedge is a core component of the strategy and not an afterthought. The idea is to capture convergence or divergence between two or more highly correlated instruments. But it is not an afterthought crutch for faulty hubris.

 

[tommcginnis]

A point of clarity: there are three types of hedges, being redundant, mirror, and uncorrelated.
Each has important uses, including in the financial world.
Most of this thread can be inferred as discussing mirror hedges.
"A lot of " this thread implies that the lifetime of a hedge is limited, and it need not be.

 

[systemtrader.org]

A hedge is not a spread.
A hedge is not arbitrage.

 

[tommcginnis]

A hedge is not a spread.
A hedge is not arbitrage.

But half of a spread is.


But a well-timed hedge sale arbitrages between two market states.

 

[IronFist]

The one situation I would call a hedge probably isn't. How can a hedge be uncorrelated? What if they both go down?

 

[srinir]

Hedges are cost of doing business.

Trading means taking leveraged position. Any extreme event can take out your book. If that small position is not a leverage trade, then hedging is not necessary.

 

[quant1]

I think you are conflating a spread position with a hedged position. The key difference is that a hedge is executed with an express purpose of reducing variance on the trade without changing the expected value. Hedge in itself has no alpha and, in fact, should be viewed as a cost. It's not uncommon to use a single hedge position for a bunch of alpha assets.

It could be very difficult to say which leg of the spread is the alpha leg. The purpose of a spread position to take a view on a relative dislocation of two or more assets.

PS. To make things more confusing, the above logic relates mostly to delta-one products. Options spreads can and should be mentally decomposed into an alpha leg plus a hedge leg.

I don't think I see a distinction between a hedge and a spread. In fact a spread is simply a position in which some exposure is hedged. For example, if you trade a stat arb between SPY and QQQ, you are effectivley hedging some general market exposure.

As for the original question, hedging can limit variance, allows one to trade synthetic exposures (like the SPY/QQQ spread mentioned above), and in some cases, can lock in arbitrage profits.

 

[sle]

I don't think I see a distinction between a hedge and a spread. In fact a spread is simply a position in which some exposure is hedged. For example, if you trade a stat arb between SPY and QQQ, you are effectivley hedging some general market exposure.

Obviously, there is no official definition, but in general you’d say “I am hedged” if you have somehow reduced your variance without a significant decline in your alpha. Since in most spread trades you would not be able to clearly distinguish which one is the alpha leg, it’s hard to make that statement.

Let’s take your example. Take a stat arb trading SPY/QQQ spread vs a long/short PM that is buying Space Sprockets Builders International (SSBI) and selling some index to short. The latter knows everything there is to know about the company (or so he thinks) and simply want to reduce his outright market exposure. The former initiated the trade because the spread is dislocated and he is actually interested in exposure to the spread as an asset. If a stat arb PM (eg yours truly) is trading a bunch of event stocks and is shorting some spooz against them, he is hedging, not buying a spread.

PS. Feels like the “what’s in a name” type of discussion - I’d say we are both right