In today’s post we are going to talk about hedging. Professional traders (market-makers) view hedging differently than retail traders (market-takers). For market-makers, hedging is a necessity. It’s part of the cost of doing business. They aren’t interested in taking any sort of position, long or short, on the underlying stock. They are simply looking to capture their edge (bid-ask spread) and have a balanced book. This is akin to a sportsbook at a casino. When a sportsbook makes a line on a game, their goal is to have equal action on both sides. They ideally want to capture their edge (the VIG in this case) and take no position on either team.

Market-makers hedge dynamically by trading the underlying stock/future in order to flatten their delta position. By using stock, or futures, they can hedge cleanly by isolating delta only. Additionally, market-makers have superior execution ability, as well as greater margin (pros call it “haircut”). That’s great for them, but where does that leave us, the market-taker? As position traders, we typically have an option position that we, hopefully, entered for edge.

So, we are faced with two questions,
• Should I hedge?
• If so, how do I hedge?

Before we answer those questions, let’s lay out some basic hedging facts,
• A hedge is designed to lose
• A hedge neutralizes the risk you DON’T want, while preserving the risks you DO want
• A hedge is meant to keep you in a position long enough for your edge to be realized
• A hedge should never turn into a directional trade
• Hedging after-the-fact is always done at edge-loss

Now that we know the rules, let’s answer the first question; should I hedge? This seemingly complex question is quite simple if you think about it intuitively. I like to look at it in terms of risk/reward. Hedging must improve the risk/reward ratio of a trade in order to be justified. How do we measure risk/reward? Solve for the trade’s max gain at peak, then add enough of a hedge to reduce these gains by 50%. If losses on the other side aren’t reduced by more than 50%, then don’t hedge. If it preserves the risk/reward ratio, but doesn’t improve it, then just reduce trade size (since you’re effectively doing the same thing). For example, a trade makes $1000 tomorrow. Add hedge, it now makes $500. What does it lose on the downside? It better be less than $500, or else the hedge isn’t effective. If it does improve the risk/reward, then add the appropriate amount to maximize the ratio.

So, say we’ve decided to hedge. What’s the best product to use? Here is my ranking for optimal products to hedge an option position,

1. Futures
2. Stock
3. ETF
4. Options

Keep in mind, we are talking about hedging delta or directional risk of the underlying. Futures are the ideal hedging tool for a few reasons. Futures are pure delta, they are liquid, and trade most of day/night. I typically use the E-mini S&P 500 (Es) futures contract as my primary hedge for a book of options positions, or for an option position in SPX. If you have a position in NDX, use Nq, and so on. Stock would be my next choice, or if you’re looking to hedge an equity option trade (buy/sell AAPL shares to hedge AAPL option trade). Alternatively, if you have an index option position, like SPX or NDX, you can use shares of the corresponding ETF (SPY or QQQ, in this case).

That’s all fine and good. But what if I don’t have the margin required to hedge with futures/stock? Then you can use options. These are my recommendations for options as hedges,
• Use in-the-money options (approximately 60-75 delta)
• Use single calls/puts, not spreads/combos
• Use the same expiration as the underlying trade
• Use a liquid contract (decent trade volume and tight bid-ask spread)

The key thing to keep in mind when hedging with options is that they will alter your trade’s other greeks aside from delta. So, try to stick with options that closely replicate a position in the underlying stock. And above all else, less is more in this case. Unless you like generating commissions for your broker, keep it simple. An option trade is complex enough on its own. A hedge is supposed to reduce stress, not add to it.

Adam M. Singh
adam@voledgetrading.com
(480) 862-9330