Yes or No:"Fully hedged portfolios are not risk free"?

Quote from Traden4Alpha:

You say its not a challenge, but then you go on to say:
This sounds like the epitome of a challenge to me.:) What you suggest is a very interesting extension of pairs-trading to baskets in an industry. It would be a huge challenge to sort the 60-70 REITs in a way that puts 20 in the long basket (i.e., those with upside reversion/movement potential) and 20 in short basket (i.e., those with downside reversion/movement potential) while keeping the two baskets nicely balanced with regard to interest rate exposure, geographic region, and office/commercial/residential category exposure. Very tricky.



This seems easier to me as long as the fraction of variance of price movement in the prime trade is relatively constant with respect to the hedged variable. E.g., if interest rate fluctuations explain 20% of the variance of price movement of my tradable, then I might take a small hedge position in something that is more directly tied to interest rate movements (e.g., an instrument tied to bonds).

I disagree that its an intentional directional play because I'm making no assumptions about whether the hedge will go up or down. I'm only hedging to remove variance due to some financial variable (e.g. interest rates or forex) that my system doesn't track.

At best you could argue that every hedge is an unintentional directional play because the short side of the hedge only adds profit when the short-side instrument drops in price. But I say this is really unintentional because if you knew the short side was going to drop, then you could trade it all by itself.

I agree with you that hedging is a way to reduce portfolio variability. I see hedging as an explicit admission of ignorance about the direction of some element of price movement. It is a way to remove risks (both potential profits and losses) associated with parts of the price movement that I have insufficient knowledge about. Thus the point of hedging is to avoid making a directional play by cancelling out directional moves that one has no ability to predict.
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You make a lot of good points so I will only address a few.

> You say its not a challenge, but then...

Finding homogenous universes to hedge is easy...
Building the quant systems to automate the hedging requires talented traders and software engineers.
(I have a Computer Science degree... plus 300,000 trades... so I'm both).

> potential) while keeping the two
> baskets nicely balanced with regard > to interest rate exposure, geographic > region, and
> office/commercial/residential category > exposure. Very tricky.

Excellent point.
Everything has to be screened and "normalized".

Example...
You would tend to hedge a REIT that specializes in office space...
With another one specializing in office space.
And make adjustments for geography, diversification/size of company, etc.

Quantitative analysis is a multi-tasker's dream.

> I disagree that its an intentional directional play because I'm making

I will stick with my original point. This takes some thought.

** Hedging any external risk is a directional bet. **

2 examples:

(1) I'm worried that the Canadian dollar will keep rising versus US dollar... so I buy the CN$ futures contract.

(1) I'm am worried that I will die... so I by life insurance.

BOTH are directional bets. The 2nd is a bet that you will die soon.
Both can be viewed as insurance with a real cost that decreases volatility.
 
Quote from HoundDogOne:

Life is not easy when you have no class "Mister 666"...
But your behavior far exceeds the ET Terms of Service.

YOU ARE HURTING ET'S BUSINESS AND IT WON'T LAST.

You can do grade school math...
But lack the basic logic skills to put it together.

first 30 years at 26%
last 10 years at 11% = 22% over 40 years

What WB did in the 60s has no relevance in the year 2006.
He has only matched the stock market the last 10 years.
That would make him yesterday's man...
But, first and foremost, WB is a carefully constructed cult.
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ROTFLMAO!!!! Let me get this straight... me giving you a much needed reality check is "hurting ET's business" BUT you posting hilarious, unsubstantiated claims of greatness and slandering Warren Buffett is good for ET's business?

You miss my point entirely you STUPID JACKASS. Warren Buffett's 22% CAR over the last 40 years WAY outperformed the market and made him the SECOND RICHEST MAN IN THE WORLD. Which makes your statement the height of false arrogance and stupidity. But I guess you don't understand that because you're too busy pretending on the internet that you're superior. Which is pathetic and obvious. So why don't you crawl back under your rock, and get back to me when you overtake Buffett on the Forbes list.
 
Quote from HoundDogOne:
You make a lot of good points so I will only address a few.
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First, thanks for your intelligent replies -- it's always nice to converse another thoughtful trader.
Quote from HoundDogOne:
Finding homogenous universes to hedge is easy...

Example...
You would tend to hedge a REIT that specializes in office space...
With another one specializing in office space.
And make adjustments for geography, diversification/size of company, etc.
More...
I do agree that balancing the baskets is not that hard at first glance. You can use fundamental analysis (as you suggest) to create matched sets. Or you can go quantitative and partition the set based on the structure of covariance matrix.

The tricky part (in addition to the automation software & systems) is deftly putting all the REITs that have a high chance of upward movement into the long basket, and none (or few) into the counterbalancing short basket. A hedge does no good if it hedges out the profit opportunity.
Quote from HoundDogOne:
** Hedging any external risk is a directional bet. **

2 examples:

(1) I'm worried that the Canadian dollar will keep rising versus US dollar... so I buy the CN$ futures contract.

(2) I'm am worried that I will die... so I by life insurance.

BOTH are directional bets. The 2nd is a bet that you will die soon.
Both can be viewed as insurance with a real cost that decreases volatility.
More...
I do see your point about hedging = insurance and that insurance can be considered a directional play. Yet I would argue that if you really think the Canadian dollar will rise, then you are making a trade more than a hedge when you buy Cdn$.

My argument is that most hedgers (especially non-speculator companies that hedge commodities) do so to guarantee a fixed cost (if they are buyers of the commodity) or a fixed revenue (if they are sellers of the commodity). In that regard, they remove the effects of both up-moves and down-moves. Their financials become independent of the direction of the price action and thus they trade to be effectively directionless. They are admitting that they don't know if the price will go up or down.

Lets put it another way. What if I knew that the price of a given instrument (commodity future or company stock) included some unpredictable random component that was effectively a game of chance such as a coin flip. Each day, a "heads" adds 3% to the price and a "tails" subtracts 3% from the price. This unbiased random component adds nothing to my long-term return, but adds a huge risks in terms of random walk drawdowns. What if I pay to avoid being exposed to the outcome of a coin-toss by shorting "cointoss" futures? Is that a directional bet against "tails" or a non-directional hedge to avoid that +/- 3% volatility? I argue its non-directional because it adds no average long-term return.

In fact, the way to prove that hedging is non directional is to realize that the hedge trade is intended to cancel out the directional effects of the prime trade. If I go long a basket of REITs, I'm making a directional trade that is long on real estate. If I then short another basket of REITs, I'm making a directional trade that is short on real estate. Thus hedging (the combination of the prime trade plus the counterbalancing hedge trade) is then directionless with regard to real estate. After hedging I'm neither long nor short real estate, long nor short the Cnd$, long nor short the coin toss.

That is why I contend that hedging is directionless. I'll concede that the hedge side of the trade does create profit when the underlying moves in a particular direction but that this profit is exactly cancelled by another trade in the opposite direction. Thus the speculator, by hedging, becomes net directionless with regard to the hedged variable.
 
so, after all this analysis, hedging is just for those who don't know which way the market is going, i guess. ?

it seems to me that being able to make money when the market is in a range would be better than thinking you could be right often enough in market moves.

k
 
Quote from Traden4Alpha:

My argument is that most hedgers (especially non-speculator companies that hedge commodities) do so to guarantee a fixed cost (if they are buyers of the commodity) or a fixed revenue (if they are sellers of the commodity). In that regard, they remove the effects of both up-moves and down-moves. Their financials become independent of the direction of the price action and thus they trade to be effectively directionless. They are admitting that they don't know if the price will go up or down.
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Good point alpha.

If I have 100 square miles of coffee and the prices are at all time highs 6 months before crop, I want to make sure to secure some of those profits in case Vietnam decides to dump it´s production at the market and take the price down...

That´s the beauty of futures... for the normal bussinessman... {eg not a freak that speculates on the future price of something that doesn´t actually exist... like us index futures traders...}:D
 
Quote from Traden4Alpha:

In fact, the way to prove that hedging is non directional is to realize that the hedge trade is intended to cancel out the directional effects of the prime trade.

That is why I contend that hedging is directionless. I'll concede that the hedge side of the trade does create profit when the underlying moves in a particular direction but that this profit is exactly cancelled by another trade in the opposite direction. Thus the speculator, by hedging, becomes net directionless with regard to the hedged variable.
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I think your definition of hedging is way too narrow. For example, sometimes it makes more sense to protect a long stock trade with puts than to use a stop... granted, your potential upside will be reduced by the cost of the puts but it's still theoretically unlimited while your downside risk is greatly reduced. You wouldn't call that hedging?
 
Quote from Trader666:

I think your definition of hedging is way too narrow. For example, sometimes it makes more sense to protect a long stock trade with puts than to use a stop... granted, your potential upside will be reduced by the cost of the puts but it's still theoretically unlimited while your downside risk is greatly reduced. You wouldn't call that hedging?
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Yes, you're right, perhaps I've been too narrow in my examples. Using options to limit the downside certainly hedges risk.

The Long + Put trade does highlight a special problem with hedging. How does the trader know that the Put isn't overpriced by the roughly same amount that the Long is underpriced -- that his trading system wouldn't give him a sell signal on the Put at the same time it gave a buy signal on the Long. If the Long is at some low price (and poised to surge), then presumably the put option is somewhat expensive. After the Long trade jumps in price, won't the Put option have fallen in price? Yes, I realize that the option's delta value dilutes the put's price move with respect to the underlying, but it does mean that buying a put gives back some % of the Long's price move. (As an aside, the strike price and expiration date of the option will affect delta in interesting ways with regard to impact on the total trading strategy, but that's a discussion for a different thread -- the put that minimizes downside risk with have a high delta).

With regard to directionality, buying the Put option is bearish and (partially) corrects for the bullish Long trade. Thus, a Long + Put is a less directional trade than a pure Long.
 
How do market neutral portfolios actually react when the market makes a strong directional move? Real life examples would be great?
 
Fully hedged portfolios are risk free. However, it is almost impossible to find a "full" hedge. There is almost always a risk element.

A good example is what happened in the silver market in the late 70s and 1980. Many producers shorted silver futures at record prices, to hedge their production. However, when the prices soared even higher, they found that their "hedge" was actually a speculative bet that silver would not reach prices sufficient to force a margin call, before their supply was able to be delivered. Thus, what seemed to naive market players to be a hedge, was nothing more than a reckless gamble on the direction of silver prices.

So, if short silver futures, long physical silver is not a true hedge, then hopefully you can see that almost *nothing* is a true hedge. You almost always have things like basis risk, credit risk, the risk of being unable to deliver etc.

There is basically no such thing as a risk free position or portfolio.
 
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