How to Make Money Hedging?

[philmg 10]

Hi, I may have a very stupid question, let's see.

 

I frequently hear and see, that traders may want to limit their risk by hedging and trade another stock/future/etc. in the other direction. As far as I understand both products should typically in the opposite direction, so they are correlated.

 

Now, I am wondering, if you do that you do not only limit you risk, but also your profit potential. Isn't the total profit often times 0 due to making a profit on the one trade and making a loss on the other.

 

How do you make money with this? Is it that you expect you trade 1 to show a larger move than you hedge?

 

I don't get it, sorry for this newb question, but it would be great, if someone could fill me in or point me to a source, where it is well described.

 

Thanks!

[BlueHorseshoe 10]

Hi, I may have a very stupid question, let's see.

 

I frequently hear and see, that traders may want to limit their risk by hedging and trade another stock/future/etc. in the other direction. As far as I understand both products should typically in the opposite direction, so they are correlated.

 

Now, I am wondering, if you do that you do not only limit you risk, but also your profit potential. Isn't the total profit often times 0 due to making a profit on the one trade and making a loss on the other.

 

How do you make money with this? Is it that you expect you trade 1 to show a larger move than you hedge?

 

I don't get it, sorry for this newb question, but it would be great, if someone could fill me in or point me to a source, where it is well described.

 

Thanks!

 

Hi Phil,

 

It's not a stupid question (no question is too stupid to ask, as a rule).

 

Hedging and what I think you're describing above are slightly different.

 

With hedging, you're not expecting to make a profit (or a loss); the goal is to 'lock-in' or guarantee the current price. Suppose you own an airline and therefore your operating costs are dependent on the price of jet fuel. You're worried that the price of fuel is going to increase significantly over the next year. So you hedge, buying in oil futures. If the price of oil increases over the next twelve months then your long futures position should make a profit that will offset your increased operating costs. If you're wrong and the price of oil falls, then you'll lose on your futures position but this should be offset by the savings in your operating costs. You've 'locked' in' prices at the current level for the next year. This is in fact the original purpose of futures and options, and the whole reason they came to exist.

 

What you consider above is perhaps more associated with Statistical Arbitrage ('StatArb'), or 'pairs trading', where the aim is to profit from the price convergence of two different assets. Assuming that the two behave in a similar way (correlation is not an appropriate measure for this though - the two need to be cointegrated), then when the spread between them widens then the one that is considered to be trading at a discount is bought, while the one trading at a premium is sold short. One does not need to be correct about both states to profit - it is simply necessary that the spread narrows over time.

 

Unlike true arbitrage, statistical arbitrage is not risk-free; it is perfectly possible that the one asset continues to be 'discounted' while the other continues to trade at a high 'premium'.

 

Hope that helps!

 

BlueHorseshoe

[SIUYA 11]

good answer by BlueHS....

Also dont get too caught up when people talk about hedging, spreading, arbitrage etc ; a lot of the time they are talking about similar things - maybe with slightly different motivations and just using the same/similar terminology.

What one person calls a hedge, another calls a spread.

 

There are additional things i might add which are sometimes involved (but not necessarily hedges) -

1....often a spread trade is done to represent a trade idea. This spread might represent the trade idea but with less (supposed) risk.

2...often using these spreads (or by putting on a hedge) allows the trader to use extra leverage to make the most out of what 'edge' or value they might see.

 

(of course this leverage can also increase the risk - see LTCM - when genius failed) and is also very topical to the hedged positions many banks. insurance agencies thought they had during the recent liquidity crisis.

[Predictor 11]

philmg

 

You are describing a perfect hedge. This is not exactly how professionals hedge. Traders can hedge with options -- which is similar to buying insurance. They can also trade a portfolio or a basket with the idea that when some stocks go down then others will go up. In general, a portfolio of low correlated assets will have a lower risk profile. Some traders may want to limit certain types of risk. For example, if I buy the SPY (with USD) then I'm implicitly long SPY and short the USD. However, if my view were such that I was bullish on both SPY and the USD then I might try to mitigate this risk by shorting Euro. This is the basic concept of many futures hedges.

 

What some traders do, and I have did this myself with some success, is to hedge a position say in Forex with a perfect hedge which is equivalent to going flat but which may produce a psychological benefit that would be similar to taking some other action: namely taking a loss to go flat and then re-entering the new position.

[veAL 10]

Hi Philmg,

 

as described before hedging is always associated with managing risk. So for example you are trading the ES and have a setup but for the valid setup your stop has to be too far away and out of your comfort zone. So you might buy weekly calls or puts on the SPYor ES to create a position similar to the ES Futures trade but with less risk (limited risk). One other example would be you are in the gains but your stop is out of your comfort zone. So you could close out your Futures contract and trade weekly options with the intention to limit your risk to a smaller degree.

With limiting your risk you do also limit your profit potential but not always ;-))

 

In my Forex account it is possible for me, as I am not an Amerikan, to hedge my position by simply going long and short at the same time. But I never did this, I rather close out the position and wait for the next shoot....

 

Happy trading

veAL

[zdo 20]

What some traders do, and I have did this myself with some success, is to hedge a position say in Forex with a perfect hedge which is equivalent to going flat but which may produce a psychological benefit that would be similar to taking some other action: namely taking a loss to go flat and then re-entering the new position.

 

anecdotally speaking - from the set of 'cases' of this I've observed, the bottomline benefits AND the psychological benefits of FX 'perfects' are minimal :doh:

ie below the surface, hedging a loss tends to prolong and reinforce the loss... ultimately ... usually ends up worse :crap:

ie only 'hedge' winners. :helloooo: .. especially in FX

... just saying...

 

The answers above are good...there are few really appropriate 'hedges' these days. One is owning phyical PM's and strategically hedging with futures... after 20 years at it i'm finally getting pretty proficient at it

 

have a great weekend all

[BlueHorseshoe 10]

 

In my Forex account it is possible for me, as I am not an Amerikan, to hedge my position by simply going long and short at the same time.

 

Spread betting? And what's with the 'Amerika' spelling, been reading Kafka?

 

With other types of accounts such as futures and fx you can do this by using two seperate accounts. I would imagine that you could probably persuade your broker to recognise the link between both accounts and use credit from the one to margin the other - does anyone have any experience with this, by the way?

 

BlueHorseshoe

[veAL 10]

Spread betting? And what's with the 'Amerika' spelling, been reading Kafka?

 

Sorry for the spelling. Used German-English or some form of it ;-))

 

We in Germany are allowed to hedge with the same account where the US do not. Spread and Commissions apply, so my broker is satisfied...

 

Cheers

veAL

[Jack Francisco 10]

we can use hedging when our order against the trend for longer time and to lock some loses then we can use hedging to save the balance and also we have the chance to convert it to profit

hedging can be used with open 2 order at the same time and make it opposite each others, then we can lock the floating minus and wait for good profit and close the other