If you’re new to trading, you’ll hear professionals talking about hedges and hedging strategies. Whether you’re looking for long-term results, medium-term swing trades, or short-term speculation, hedging is the most important thing to learn. It’s what gives you the added edge you’ve been trying to find. So, what is a hedge, and why does it help?
Hedging is a term borrowed from ancient farmers who used to build borders of shrubs—hedges—to form protective barriers around their property. It was a way of saying, "This is mine. Keep out." When you use a hedging strategy, you’re building a protective barrier around your positions. Sometimes, you'll hear them called "hedgehog" strategies after the animal with sharp spines that curls up in a ball to thwart predators. Whether with shrubs or spines, the barrier reduces—or even eliminates—risks you don’t want to accept. That’s where options come in. But wait, how can options dodge risk when they’re so risky?
Well, that would be a good point—if it were true. Options were designed as hedging tools—not as the gambling games the financial press would have you believe. Options can be used in risky ways, but the better way to understand them is they allow you to alter risk. You can use them to increase leverage, accelerate gains, and make profits and lightning speeds. But those strategies can also lose money just as fast. Higher risks equal higher rewards.
However, by using risk-free strategies like box spreads or conversions, you’ll earn the risk-free rate. After all, if there’s no risk, there’s no reward. So, even though it’s counterintuitive, you can use options to create positions that behave like Treasury bills or bank CDs. Just don’t expect to get rich doing it. Options don’t allow you to put the risk-reward barriers into a time warp where you can eliminate risk but be guaranteed to buy out Microsoft. That’s not finance, that’s sci-fi.
Options can be used to create any shade of risk between these two extremes that you’d like. It all depends on how you create the hedge. But what’s the benefit of a hedge if it’s just altering risk and reward? This is where Spike the Hedgehog meets Kismet to combine hedging with the art and science of options trading. He’s the hedging master who can deflect, block, and parry ever risk that comes his way. If you want to see changes to your trading results, you don’t need new strategies. You need to understand hedging.
The Art & Science of the Hedge
Once you learn to hedge positions, you can create positive expected edges, very much like a casino. That doesn’t mean you can’t lose—casinos lose all the time. But they earn over the long run, which is partly why they’re open 24 hours a day. The longer the cards are dealt, the bells are ringing, and the roulette wheel is spinning, the more money the casino makes. The small edges give them big long-run edges. Why do hedges work?
Let’s say you work in an office with a football pool. Each week, a sheet is passed around where you can bet on one of two teams—A or B. To keep the math simple, let’s also say there are just two people in your office. It won’t be much of a football pool, but it’ll save 100 pages of details.
For each game, both teams are equally likely to win. Right now, it seems there’ll be no long-run advantage. You’ll probably win half the time and lose half the time. It may be fun, but it won’t be profitable. Can hedging help?
Let’s say your co-worker bets $10 on Team A. If you but $10 on Team B, you just set yourself up for one of the worst trades in finance. You can either double your money—or lose it all. It’s an extreme outcome, and a basic premise of financial risk management is to avoid extreme outcomes. They just expose you to a lot of risk for nothing. Keep doing it, and it’ll take just one trade to blow up your account. Let’s not do that. What can you do instead?
Did you forget already? Hedge!
Rather than bettering $10 on Team B, you create a hedge. You bet $10 on Team A and the same on Team B. You’ve got $20 into the pool, so what can you expect to happen?
If Team A wins, all the money swings over to that side of the bet. There’s $30 there (your $20 and your co-worker's $10), which is divided between the two of you. You take home $15, but spent $20, so you lost $5. But what if Team B wins?
Now the $30 swings to that side of the bet—but you’re the only one betting on that team. You collect the entire $30, but because you paid $20, you’re up $10. Now think about what happens in the long run. Because both teams are equally likely to win, you’ll win $10 half the time and lose $5 half the time. In the long run, you can expect to win $2.50 each week.
Just like a casino, that doesn’t mean you’ll win $2.50 each and every week. Instead, you’ll either lose $5 or win $10, but in the long run, the profits will work out the same as if you earned $2.50 each week. If you played 100 times, you could expect to win $250. It’s much better than zero. And the only reason you now have a positive expected edge is because you hedged the position. It’s not magic. It’s the art and science of hedging.