Hedging Trading Strategies (Backtests And Examples)

Last Updated on October 10, 2022 by Oddmund Groette

Every investment comes with the risk of loss, but it is possible to limit such risks using hedging strategies. Hedging trading strategies are useful tools that every investor should be aware of, but what exactly is hedging?

In the stock market, hedging is 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 loss of an existing position. Hedging works like insurance, shielding an individual from the possibility of losing all of their money.

In this post, we take a look at hedging and the strategies for doing that. At the end of the article, we provide you with some examples and backtests of hedging trading strategies.

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. Hedging is not commonly used by retail investors, 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 orders 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 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 substantially similar to the one they are buying so that if there is an overall market decline, the profits from the short position would offset the losses in the main position. In short selling, an individual profits when a stock’s value falls rather than when it rises.

There is a wide variety of hedging methods exist, and each one has its advantages. Different financial instruments are required to implement various hedging techniques, each of which mitigates a different level of risk. To achieve the best results, investors can employ a variety of approaches.

What is a hedging strategy? Example

Hedging techniques can be used by anyone. 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. In financial trading, a stock trader can use it to protect their stock portfolio. Here is an example to show 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.

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.

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 in buying undervalued stocks and shorting overvalued ones.

Pair trading: 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 would 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.

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.

Hedging trading strategies – backtest

Backtests and examples of hedging trading strategies are coming soon.

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