Trade Rules: Hedging

Well this topic is long overdue. I have been talking about making a post for quite a while now and I finally found some time to do so. I have to admit, hedging is probably one of my weakest skills and I continue to struggle with hedging correctly.

Overview
In its most basic form a hedge is a counter position trade. Let’s assume you have a core long position in SPY. In the scenario the market overextends itself on the upside and signs of a reversal or retracements may near you have 2 choices; either take a partial profit, or buy insurance as a hedge against your core position.

So if you had $100K of spy shares, and you have a chance of a reversal you may decide to buy a spy put or even an inverse to SPY such as SH or SDS (proshares).

So we all know that already so let’s get a bit more technical.

Why to hedge?
For me I have a very simple rule when it comes to hedging, I want to protect my open profits and my core positions. A hedge is quite tricky emotionally as it’s a position against your core direction and belief. So you will be hesitant to take this position as you do not believe it will go into this direction – so forget about direction but think about your open profits. The other main reason is that your core position price and time targets for taking profits may conflict with the current market moves - so trade your plan on your core longer term position, but protect yourself from unforseen short term moves.

Sizing
The most important thing about hedging is the size you want to take for insurance. You need to come up with proper conversion mechanisms that allow you to properly identify the size of instrument you want to use as a hedge. When hedging using ETFs you only have to worry about size, when using options you also have to consider time and strike price as well. I am not going into detail here on hedging via options as they are many articles out there that explain the different type of hedging strategies using options. Just be aware of the time component that can play some tricks on you. Of course it gets more complicate depending on what you are trading, futures, etfs, stocks, options, etc. When trading SPX (which most of us do here using various methods) you can always calculate it all back to your full SPX buying power and convert it back to the other instruments.

For me, the first step as a hedge is generally a 30%-40% size against my core position. The largest I generally go up to us 60%. There are rare instances when I hedge myself by 100%, and that generally ONLY happens after I had a strong run into my direction and met a profit target but are hesitant to take profits; OR the other most important instance is when I believe that the market is overextending itself beyond specific boundaries. This is especially important when you enter new core positions at specific breakout ranges. There are many strategies for entries, most of them are accompanied with stops, but as mentioned there are instances when I use a hedge instead of a stop.

Some basic rules I follow for hedges

Never hedge during trend days. This one has burned me quite a lot in the past. Let me give you an example. I had build up a wide range of short positions that I had held through a lot of pain with the anticipation of nice gains. The market opened with a nice GAP down putting all my positions close to break even, the market continued to trend lower and I saw open profits, excited that the pain zone had been removed I entered a big hedge as I did not want to see reds again. I kept on getting stopped out as we moved lower and I kept on hedging in larger and larger ratios. End result for the day, short positions up 5% for the day, loss due to hedging 4%. It happened again a few weeks later in a similar situation but I stopped hedging after the first failed attempt. The end result for the day looked a lot better but still a loss on the hedge and less profits at the close of the day.

So as a result, during stepping days (trend days) I let the profits run, yes the chance of an intraday reversal is there but it is very small and if it does occur it would put me back to where I started. Highest probability is a winning day. Think about this, if you have 5 different trend days in your positions favor, you may get one that has an intraday reversal, even if that happens you can hedge once the market fills the gap. In the end – it’s not a loosing day after all. So do not try to get fancy when the market is moving strong into your direction. FYI: Stepping day is a GAP of at least 0.80% (preferably 1%) with high/low of day being set within the first 10 minutes close to the open price. Other trend day scenario exists but this is the most common.

A hedge is not a trade – this is another one that I had to learn the hard way. A hedge is meant as insurance to keep my open profits at a level I desire. A hedge is really just there to keep this one number on my screen at a level I want. It should NEVER be considered a trade. If your hedge ends up making good gains, well then you need to re-evaluate your core position as you may be in trouble and the market has turned against you without you realizing it. The topic of gains on my hedge brings me to another new rule.

Only exit on a hedge is break even stop – this is pretty new to me and many may disagree. But a hedge will ONLY EVER be closed out at break even (sometimes a bit below depending on the entry). This here is probably the most difficult rule to follow but it supports the rule “a hedge is not a trade”. In the past I had closed out hedges after a few points because I felt that I got lucky locking in some profits on a counter trend trade (against my trade plan). Big mistake, market kept on moving and my core position kept on declining in value. So if you want to profit off a short term move on the market enter 2 trades, one as a hedge, and one as a short term trade using a DIFFERENT instrument. This will help separating the hedge gains from your gains using another instrument. I have been considering creating another account only to be used for hedging and removing the open positions from my UI to not trick me into closing out. While this account would be a looser it would get funded continually from gains made using my core positions. The important component is the balance on all your accounts at the end of the day that’s what you want to protect.