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Hedging vs Stop Loss Which is Better

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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).

Note: In my course all strategies are properly hedged.

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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About the author: I started trading stock markets since 2007. However my first 3 years were losses. Then I dedicated almost 1 year on studying, researching, paper trading options and learned a lot in that time. Since 2011 I am trading Nifty options profitably. Call me if you need any help trading options on 9051143004.

{ 8 comments… add one }
  • michael

    Great article, Thank you for writing and posting it

    Great point on ONLY using a GTC for when you are Day trading and will close out all trades by the end of the market close, as well as be there to watch the market and your trades for that given day

    Hedging with a Long Put on the ES , when you’re Long say the ES intraday and are planning on holding the position overnight , is a great method

    I did have a question please , on buying options on the Futures

    Say we are long a position on the NQ and we want to hold this position overnight … so to hedge this position , would we HAVE TO buy a Long Put on the NQ , or could we buy ” Cheaper ” options on the NQ’s ETF , I.E. the QQQ ?

    Thanks so much – Michael

    • Michael,

      Glad that you liked. Hope it helps you trade profitably there in the USA. 🙂

      To answer your question I am not comfortable hedging one instrument with another instrument even if they are related. That’s not real hedging. I also see that there is a huge difference between dollar value of one contract of NQ and dollar value of one contract of ETF. In fact there is BIG difference – the ratio of NQ:QQQ stands at 1:800 approx.

      There is no way you can hedge it with buying cheaper puts of QQQ. Please remember whenever you hedge the dollar value of both contracts should be same. Agreed ETFs are cheaper but they will be helpless in case there is a crash. The kind of money you make from puts will be negligible.

      If you really want to save money, then buy slightly out of the money puts. They will also give a great protection – but it starts only after some loss is taken. ATM options are costly but they start protecting from day 1. You lose some, you gain some – that’s the puzzle you need to solve. 🙂

      Hope that answers your query.

      Thanks.

  • michael

    Hi Dilip ,
    I just want to make sure that I understand correctly …..

    So with hedging a Futures position,
    you actually buy an Option on the Future itself ?

    For example:
    If we have a Long position in CL , and with us swing trading this position ( hold it overnight ) , to properly hedge , we would buy a Long Put…. At or slightly OTM , on the actually CL contract itself ?

    You can’t properly hedge in this scenario, by buying a Put on the ETF that mimics CL , such as the USO ?
    It has to be an Option on the actual Future ?

    What would we do to properly hedge ourselves , on a Future that didn’t have Options , or that maybe has Options, but has very low volume traded on it’s contracts and or little to no Open Interest on those contracts …… such as Orange Juice, Sugar, Cocoa , Heating Oil, Wheat, Oats, etc..

    Thank you again for posting and sharing your articles,
    I greatly enjoy reading them , and they have helped me a lot in my understanding and gaining of knowledge in all things Options

    Thanks so much – Michael

    • Yes true. Option and Future have to be on the SAME stock and if possible of the same expiry. You see the Future delta is always 1 (they move 1 on one with the stock), but the options delta is almost always less than 1 (all ITM option’s delta gets closer to 1 near expiry, and others go closer to zero. All ATM options delta is close to 0.5). So in case you are correct you make more than you lose. In case wrong – the max loss is the price paid for the option if it was ATM option. For OTM options its also the distance + price paid. That is it – if you want just do not take a Stop Loss if you are comfortable with the max loss. You can always calculate the max loss even before you trade. Who knows before the expiry the stock reverses into profit?

      On stocks that are not very liquid I would rather not trade. There are hundreds of stocks that are highly traded – why take unnecessary risk on a stock that’s poorly traded? Take it from me these stocks are the ones who trap traders for years. One of them may give you a 20% return in a single day – the other will wipe your account. So just stay away from small stocks. Trade where there is money. Where there is no one trading how will you make money?

      Welcome Michael for asking some good questions. 🙂

  • marina s rao

    Dilip ji,

    Namasthe.

    Learning points from this post :

    Experts in managing losses end up making money.

    For intraday trading stop loss plan is better & for Positional trading Hedge plan is better.

    Plz correct the following line :

    In 9th para from the end starting ‘ Consider this scenario – ‘ :

    two trades take Future buy positional trade in the same stock and leave it overnight.

    as

    two traders take Future buy positional trade in the same stock and leave it overnight.

    ThanQ.

    M S Rao

  • marina s rao

    Dilip ji,

    Namasthe.

    Learning points from replies to comments on this post :

    Hedging one instrument with another instrument even if they are related is not real hedging.

    Trade where there is money.

    ThanQ.

    M S Rao

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