Hedged Trading to Limit Systemic Risk
December 15, 2014It is well known that hedging is crucial for preventing sharp trading losses.
This blog looks at the advantages of using diversity to reduce systematic risk and gives ideas on how to establish hedged trades.
When Systematic Risk Becomes a Real Threat
- Systematic risk affects the entire market. Broad market movements can turn otherwise good trades into losses and can make poor trading profitable (as has been the case in a five-year bull rally). When trading in time horizons longer than 10 or 15 minutes, systematic risk starts to become a real threat.
- With hedged trades, market direction is much less likely to dictate success, as trades are typically constructed with a combination of long and short positions.
Note the following example. A trader takes a position in Ford. Shares are up $0.10 (0.5 percent) while the market is flat; the trade looks like it will be successful. However, Russia announces it will begin military activity on the Ukrainian border and the broad market begins to sharply sell off.
What was a profitable trade is now in the red. That does not mean the pick was necessarily bad. With hedged trades, the key is to focus on benchmark returns.
Shorting the Market
- One of the simplest ways to do this is by shorting the market, such as selling the SPDR S&P 500 ETF, SPY or another index. In the case of the example above, if the trader is long Ford and short the market, returns will be generated from the broad market sell-off.
- If the trade is good, the short hedge will drop further than the security purchased and there will be a net gain. Conversely, if the market moves higher, the primary security will rise further than the hedge. This will still generate gains.
If the trader chooses wrong, the hedge will limit losses in the same way that it limits gains.
Specific Hedging
- Hedging goes far beyond the market as a whole, such as an industry, currency or security. The more specific the hedge, the more accurate gains and losses reflect trader ability rather than market trends.
- A stock specific hedge is typically constructed through buying/selling one and doing the opposite with a closely-related security. Characteristics to look for when finding the other component of a pair include industry, market capitalization, price, multiples and change over a relevant time period.
The advantage of choosing two very similar securities is that market movement or fundamental data that would affect a select group of stocks significantly more than others is accounted for. A drawback of this approach is that a news item that affects the hedge specifically can result in grossly unexpected gains or losses.
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