How to Hedge Risks Like a Pro

Hedging allows you to minimise the uncertainty of your earnings from trading and investing, while limiting potential losses. During uncertain times, seasoned traders develop strategies that include hedging. This also protects your portfolio from the tax implications of selling a position.

1. Building a Hedging Plan

Hedging ensures that you have taken positions so that if one asset declines, the other gains, and your net loss is contained. An effective way to do so is to measure the correlation between assets. This offers insights into how deeply the two are linked and whether the growth of one will mean the decline of another.

Here are a few calculations you must do to effectively hedge your portfolio:

A. The Correlation Coefficient (R)

This measures the direction and strength of the relationship between two assets. A positive correlation suggests that the price of the assets tend to rise and decline together, while a positive correlation means that the price of one asset typically rises when the other declines.

Formula

Here,
r = correlation coefficient
Σ = symbol for sum (addition)
x and y = prices of the two assets over a period of time
n = time period

With this formula, “r” is always a real number between -1 and 1, indicating in what direction and how strongly two assets are related. It uses the past price movement data of the two assets over an extended period. The longer the period of consideration, the higher the accuracy of the correlation coefficient.

Here’s how the correlation coefficient is interpreted:

B. Hedge Ratio

HR compares the part of a position protected by hedging with the size of the entire position. Here are the steps to calculate this:

• Step 1
  Determine your total exposure (total amount you can lose if your prediction goes wrong).
• Step 2
  Determine the total hedge position (amount put into an asset with a negative correlation).
• Step 3
  Divide the hedge position by the total exposure to get the hedge ratio.

Example
Let’s say, you’re long on stocks worth $10,000. To offset the exposure, you invest $2,500 in US dollars. Here, you’re hedge ratio is $2,500/$10,000 = 0.25. This means 25% of your stock positions are hedged by US dollars.

The shortcoming of this method is that it does not suggest the optimal level of hedging. For this reason, seasoned traders often use the minimum variance hedge ratio instead.

C. Minimum Variance Hedge Ratio

Perfectly hedging all your risks is impossible and is not even desirable, as this would mean you earn no returns either. The aim is to find the optimal levels of hedging needed to offset undue losses. This can be done by calculating the minimum variance hedge ratio, which is also called the optimal hedge ratio and is used extensively for cross-hedging. It helps you decide the size of the hedging position required to hedge an existing trade.

Optimal Hedge Ratio = r x (σx / σy)
Here,
r = correlation coefficient between the two assets
σx = standard deviation of changes in the price of one asset
σy = standard deviation of changes in the price of the other asset

Multiplying this ratio with the current value of your portfolio will tell you the optimal position size to open.

Example
Let’s say the calculations yield a ratio of 0.45. If you have a stock portfolio worth $10,000, you could need $4,500 worth of US dollars for hedging.

2. Things to Remember When Hedging

There is a need to continuously align your hedging strategy with changing market conditions. Since the value of your portfolio will change over time, so should your hedges.

A. Hedge Effectiveness

This measures the extent to which the cashflows of a hedging position offset those of the hedged assets. It helps gauge how well your risk is managed. It’s important to assess hedge effectiveness on a prospective and retrospective basis.

B. Static and Dynamic Hedging

Some traders leave their hedged positions constant overtime, while seasoned traders follow a dynamic hedging strategy. They keep increasing or reducing the hedging contracts over time to maintain a more consistent hedge ratio.

3. Popular Correlations

CFDs are considered a good way to hedge assets as they allow traders to speculate in both rising and falling markets. Adding assets that are uncorrelated or negatively correlated is also a great way to diversify your portfolio.

For instance, a stock-heavy portfolio can be balanced by adding bonds. Although bonds tend to offer much lower returns than equities, they have a negative correlation to the stock market. This is a popular way to hedge market downturns.

Cryptocurrencies were earlier used for hedging against stock market uncertainties. However, more recently they have exhibited a positive correction with equities. Cryptos are still a popular asset class to hedge against fiat currency risks. Also, given their potential for yielding outsized returns, seasoned traders allocate 1-3% of their capital toward cryptocurrencies as a hedge against more gradually moving markets.

Within stocks, some industries are considered good hedges for another. For instance, growth stocks are hedged by adding utilities and REITs to the portfolio. The oil sector has exhibited negative correlation with the casinos, gaming, airlines, and aerospace sectors.

Seasoned traders also use averaging down as a way of hedging. Averaging down means acquiring more of an asset that is declining, so that when it finally reverses, the losses are offset.

Key Takeaways

• Seasoned traders analyse the risk-return tradeoff for portfolio diversification.
• Remember that the price of overhedging is a reduction of profit potential.
• Calculate the correlation coefficient to add a variety of assets with more negative correlation for hedging your portfolio.
• The hedge ratio and minimum variance hedge ratio are used to manage position sizes while hedging.

Open a live account with ADSS.