Every investment comes with the risk of loss, but it is possible to limit such risks using hedging strategies. Hedging trading strategies are valuable tools that every investor should be aware of, but what exactly are hedging trading strategies?
In the stock market, hedging trading strategies are a way to protect your stock portfolio. It is an advanced risk management strategy that involves entering an offsetting position (long or short) to potentially help reduce the risk of a loss in an existing position. Hedging works like insurance, shielding an individual from the possibility of losing all of their money.
In this post, we look at hedging and the strategies for doing that. At the end of the article, we provide some examples and backtests of hedging trading strategies.
Table of contents:
What is hedging?
Hedging, in the financial markets, is a way to protect your portfolio. It is an advanced risk management strategy that involves entering an offsetting position (long or short) to potentially help reduce the risk of loss of an existing position. Retail investors do not commonly use hedging, but institutional investors don’t joke with it as it helps them protect their portfolios. It is typically implemented at some point after an initial investment is made to protect it from risks.
While retail investors make use of stop-loss strategies to limit their risks, institutional investors make use of hedging to protect the downside of their investments.
Hedging works like insurance, shielding a portfolio from the possibility of losing all or a lot of its money. Many financial instruments or market techniques can be used to mitigate the risk of price swings that could adversely affect investments.
For example, to hedge a position, one can short a stock similar to the one they are buying so that if there is an overall market decline, the profits from the short position will offset the losses in the main position. In short selling, an individual profits when a stock’s value falls rather than when it rises. You can read more in our article about short selling trading strategies
A wide variety of hedging methods exist, each with its advantages. Different financial instruments are required to implement various hedging techniques, each of which mitigates a different level of risk. Investors can employ a variety of approaches to achieve the best results.
What is a hedging strategy? Example
Anyone can use hedging techniques. A wheat farmer can use it to manage risk exposure to their harvest, and an airline company can manage costs by hedging the cost of jet fuels. Producers of goods and services have many incentives to hedge their risks.
In financial trading, a stock trader can use it to protect their stock portfolio. Here is an example to show you how:
Let’s say an institutional investor bought 1000 shares of AB stock at $300 per share in January, and some months later, the stock is trading at $250. If this investor does not want to sell the stock for any reason — it would still increase over time; he doesn’t want to incur a taxable event; and the difficulty in loading up again — but wants to reduce exposure to further losses, they may want to hedge it with an options strategy. To hedge this position, they might use a protective put strategy, whereby they buy put options on a share-for-share basis on the same stock.
Selling puts can even be a stand-alone strategy, just like we explained in is selling put options a good trading strategy?.
Puts allow them to sell the stock at a given strike price, during the time the contract runs. They could choose to buy a put contract with a strike price of $240. This would protect the portfolio from additional losses below $240 during the duration of the contract runs. After expiration, the contract cannot be exercised.
What are the types of hedging techniques and strategies?
There are many different hedging techniques traders and hedge funds use. Some of them include:
Market neutral positions: This is where a trader enters an equal amount of long and short positions in different stocks. For example, the trader can have $50,000 worth of position in the market. Out of this, $25,000 is a long position in Stock X and the other $25,000 is a short position in stock Y. The idea is that whichever direction the market goes, the profit in one would offset the loss in the other. This is often planned in such a way that the long position is in a stock that has a higher rising potential, while the short position is in a stock that has a higher falling potential. This is a typical hedge fund strategy.
Long-short equity strategy: This is similar to the market-neutral method in that it involves going long in one stock and going short in another, but in this case, there is a bias in one direction — usually a long bias (130/30). The long-short strategy also focuses on buying undervalued stocks and shorting overvalued ones.
Pairs trading strategy: This is a form of the long-short equity strategy, but in this case, the two stocks must be correlated. The idea is to take opposite positions when the correlation seems to fall apart with the hope that they will converge later.
Hedging with derivatives: This involves hedging with derivative contracts, such as forwards, futures, and options. Futures and options are the two most commonly used hedging methods among institutional investors.
Diversification: Diversification means not putting all your eggs in one basket. It is the idea of investing in different uncorrelated assets so that if one declines and losses money, the others may rise, and their profits would offset the losses in the declining assets. This includes building a portfolio of stocks, bonds, commodities, and other assets.
Derivative hedging strategies
These include the use of derivative contracts for hedging purposes. Common derivatives that can be used for hedging include forward contracts, futures, and options. For example, an investor with a long stock portfolio can open a short position in futures to hedge the downside of his stock portfolio.
Option hedging strategies
Institutional investors use options strategies to hedge their investments in stocks. The common options methods they use include:
Buying a protective put option: A put option gives the buyer the right, but not an obligation, to sell his stocks to the seller of the option at the agreed strike price before the expiration of the contract. As in the example discussed above, an investor can buy this right to protect his portfolio from any downside risk below the strike price. It works like an insurance premium. See below for more on selling puts.
Selling a covered call option: Here, the investor writes a call option for a premium that could help offset the risks of holding the stocks. It is a covered option because the investor already has the stocks. You can read more about this option further below.
Hedging trading strategies – do they work? Backtest and example
Let’s go on to look at several hedging trading strategies. As mentioned earlier in the article, there are many ways to hedge. We’ll go through some of the most common hedging trading strategies:
Hedging trading strategy: Covered calls
When you buy a call option you have the right to buy the stock at a certain level (strike) at a specific time (expiration). However, if you instead sell a call, you act as an insurance agent and are obliged to sell to the owner. That is risky because a stock can theoretically rise unlimited.
But if you own the underlying stock you write calls on, you are somewhat hedged. Thus, it works as a partial hedge.
Assume you own 100 MSFT. You can hedge this position partially if you sell one call. If MSFT trades at 250, you can sell calls with strike 275 6 months into the future (the expiration date). If you get (for example) 5 USD per call, you are thus lowering your purchase price by 5 USD. The option premium you receive for writing a call is yours to keep. The downside is, of course, that you are obliged to sell MSFT if the price goes above the strike of 275.
Covered calls are just a partial hedge. Is this a good strategy? We looked at covered calls writing in a separate article and looked at empirical results.
Hedging trading strategy: Tail risk hedging strategies
Nassim Nicholas Taleb became famous for his theories about black swans and tail risk.
There are several ways to hedge against tail risk. We list the most obvious ones (put options, futures, and the Barbell Strategy):
Hedging trading strategy: Put options
The most obvious tail risk hedge is put options. If you have a broad stock portfolio you can simply buy put options on the S&P 500 and you’ll be mostly covered. The most likely option is to buy deep out-of-the-money options because they have the lowest premium but also the potential to rise in value if the markets head south fast.
Put hedging costs money and most options expire worthless, thus, you must expect worse performance if you add puts as a hedge. How much? The table below gives you an idea of the potential cost:
We have covered tail risk hedging in detail in a separate article:
- Tail hedge strategy
Hedging trading strategy: Short futures
Instead of using put options, you can also short S&P 500 futures. However, futures don’t offer you the option of choosing different strike prices and thus, we believe options offer more flexibility.
Hedging trading strategy: Nassim Taleb – Barbell Strategy
To counter tail risk Nassim Taleb looked at another idea of constructing an antifragile portfolio: the Barbell Strategy.
The barbell refers to the barbell that weightlifters and bodybuilders use (Taleb is an avid weightlifter). The reason for the barbell analogy is that your assets and strategies should be binary from each other. While one side has “low-risk assets”, the other should contain “high-risk assets and strategies”. No middle ground!
The Barbell Strategy is best illustrated in a chart:
We are fans of Taleb’s and have written a long and detailed article about both his thinking about the Barbell Strategy:
- Nassim Taleb investment strategy
Hedging trading strategy: Pairs trading
When we started our prop trading strategy careers, we did pairs trading. Why?
At the time (2001), competition was low and the movement was faster due to NYSE’s specialist system. Because the specialist used to “sweep” the order book to fill market orders, we frequently got significant price improvements for our limit orders and thus bigger profit potential. When we were filled either long or short in one leg of the pair, we rushed to hedge our position by taking the opposite position in a “similar” stock.
The main idea of pairs trading is to hedge both long and short. It’s far from a bulletproof strategy, but it worked nicely two decades back, but we believe it’s not as good anymore.
Please click here If you’d like to see a recent backtest of a pairs trading strategy (including statistics and historical performance).
Hedging trading strategy: Long-short equity strategy
A somewhat similar strategy to the pairs trading strategy is the long-short equity strategy. It’s a hedging strategy whereby a trader takes long positions in stocks that he or she assumes will rise and, at the same time, takes short positions that are expected to perform weaker. It’s the difference between the two positions that will eventually determine the profits and losses. The strategy is more or less the same as a pairs trading strategy.
Practically everyone who does hedging strategies via long-short equity strategies uses quantitative analysis. The innovator for this approach was Edward Thorp – the father of quantitative investing. He is famous for his ability to identify inefficient areas of the market and figure out ways to take advantage of mispricing.
Ed Thorp is also famous for being the one who beat the dealer at the Blackjack table, something he covered in his book called Beat The Dealer.
The track record of Ed Thorp is very impressive:
Thorp founded his hedge fund, Princeton Newport Partners (PNP), in 1969 and ran it till 1988. He never had a losing year and compounded at 19.1% – more than double that of the S&P 500 with significantly less drawdown. Due to some troubles with employees, Thorp decided to close his hedge fund.
Jim Simons may be more famous than Ed Thorp, but we believe Mr. Thorp deserves more credit for his quantitative approach and innovations.
In a separate article, we made a long-short equity strategy backtest.
Hedging trading strategy: diversification
You are most likely a retail trader and many of the options above are not relevant or challenging to implement. The most rational approach for you might be to add diversification. You want to trade different asset classes, different time frames, and different market directions. This is a topic we have covered in multiple articles. The most relevant articles are listed below:
- What does correlation mean in trading? (Trading strategies and correlations)
- Uncorrelated assets and strategies – benefits and advantages (examples and backtests)
- Does your trading strategy complement your portfolio of strategies?
- Why build a portfolio of quantified strategies (including two strategies)
List of trading strategies
We have written over 800 articles on this blog since we started in 2012. Many articles contain specific trading rules that can be backtested for profitability and performance metrics.
The trading rules are compiled into a package where you can purchase all of them (recommended) or just a few of your choice. We have hundreds of trading ideas in the compilation.
The strategies are taken from our list of different types of trading strategies. The strategies are an excellent resource to help you get some trading ideas.
Hedging trading strategies – conclusion
Hedging trading strategies are popular, but it comes at a cost. There is no free lunch in the financial markets! We mentioned the most relevant hedging trading strategies:
- Covered calls
- Buying puts
- Short futures
- The Barbell Strategy
- Pairs trading
- Long short strategy
- Diversification
Hopefully, we have managed to explain the main logic behind each. Our tip is to use the last on the list: diversification.
FAQ:
How does hedging work in the stock market?
Hedging trading strategies are advanced risk management techniques used in the financial markets to protect portfolios from potential losses. In the stock market, hedging involves entering an offsetting position to protect a stock portfolio. It acts like insurance, helping to shield investors from the possibility of losing all or a significant portion of their invested money.
What is the purpose of hedging in financial trading?
The primary purpose of hedging is to mitigate the risk of potential losses. It is typically implemented after an initial investment to protect it from adverse market movements. Hedging acts as a safeguard against downturns in the value of assets.
How does diversification act as a hedging strategy?
Diversification involves investing in different uncorrelated assets to spread risk. If one asset experiences a decline, the profits from other assets may offset the losses. Diversification is a straightforward way for retail traders to implement a form of hedging.
