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In my last article how to control greed as a trader, I had written two plans to make sure any speculation you do in your trades is properly managed by a trading plan so that one big loss does not wipe your entire account.
For traders restricting losses is very important. Only those who expertise in managing losses end up making money.
See I am not giving emphasis on profits. What I am actually giving emphasis is on restricting losses through a proper risk management plan. Once that is in place the profits will come.
I think every trader knows that there are two ways to restrict losses – one is to take a stop loss (get out of the trade when a per-determined loss is reached) or hedge the trade with an exact opposite trade (so that if the original trade is losing money the hedge trade makes money).
Now the biggest issue with many traders is what risk management plan to chose – stop loss or hedging?
Frankly it mostly depends on your comfort level with the kind of trades you take. Most of the traders I have met or seen take the stop loss plan. Well I have my own apprehensions with the stop loss plan.
In my view and experience the hedge plan is better than a stop loss plan especially for the positional trades.
For Intraday Future or Option trades the stop loss plan is better because on the day the trade is making money – the trailing stop loss method will work much better than the hedge method because it will make amazing money in a single day. However had you done a hedge strategy it would severely restrict the profits. And in trades that makes the loss, the stop loss will ensure a small loss. Benefits of the stop loss method ends here.
For the positional trades the hedging method far surpasses the stop loss method. It saves you from overnight exposure of the open trades.
In the US there is something called the GTC order. It's known as Good Till Canceled Order. A GTC order is valid until it's executed by the system, or is canceled by the trader. If kept open and not triggered, it gets canceled by the system on the expiry day. Which means it stays active overnight even during holidays when the markets are closed. So if next day the stock gaps against a Future or option when the markets open and if the GTC order is within the trigger range – it will get triggered by the system and stop your losses the next day or any day before the expiry as soon as the stock reaches the trigger level. It is another story that it has its own problems, but that's beyond this subject.
Unfortunately in India we don't have the GTC order. I sincerely hope they introduce it as soon as possible. This will tremendously benefit traders. Since there is no GTC, the only option to stop a huge loss is to hedge a position. You may have a stop loss in mind – but what if the stock gaps 20% below your last closing and you had a Future buy? Gone – months of profits gone!
Hey by the way, a GTC is also helpless here as the range will get triggered and the stop loss will hit with the stock being down 20% against the trade. That's the reason why many traders even in the US do not usually put the GTC. They do it every day when the markets open and close it when it closes.
In India the only option to stop yourself from unlimited loss overnight is to take the hedging position. Not only can you sleep better at night thinking an insurance is there to save you from unlimited losses but also you have enough time to think to take the next action.
Consider this scenario – two traders take Future buy positional trade in the same stock and leave it overnight. One will take a stop loss if the stock goes down 5%, the other has hedged it by buying a ATM Put. There is a very bad news on the company after market closes and next morning the stock crashes and opens gap down 10%. The trader with the naked position was not only able to sleep well in night but had already decided to take the stop loss as soon as markets open at 9.15 am in the morning.
The trader with the hedge position will sleep well in night because he knows the protection is there to save him from huge loss and the max loss he will face will be a few points he paid to buy the protection. Within an hour or two the stock may reverse decreasing his losses by a huge margin or may get back into profits, who knows?
This the hedge trader clearly knows that the stock may reverse and he is in his liberty to take the stop loss any day before expiry. In fact, if comfortable with max loss, he can leave the trade till the expiry day. Well let me tell out of experience that a lot of times the stock actually reverses and takes the loss trade into a profitable one by the time the expiry arrives – sometimes much before that. 🙂
For the stop loss trader the game was over long back.
Can you now see the beauty of hedging vs stop loss? Hedging also does the same thing i.e stop your losses but it does it in a much better way. I am still confused why Indian traders DO NOT hedge their positions especially if they leave it open overnight.
I agree that the upfront cost to hedge your trades seems a bit too much, but whats wrong in paying a small price now than paying a much bigger price when the accident actually happens?
If you are a trader who falls into the taking the stop loss when time comes, please think of hedging your positions. Practice with half of your trades and after three months compare the profit and loss of both the risk management methods. I bet you will switch over to the hedging risk management method once you see the benefits.
Before I finish let me tell you options were invented as a hedging tool and not as a trading tool. Its a different thing that today traders all over the world use it as a trading tool. Well nothing wrong with that. But even if trading options why not hedge them with options?
To conclude my experience says the hedge plan is better than the stop loss plan. Please let me know your views.
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