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How to Best Hedge A Future Trade

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In this article we will learn how to best hedge a future trade, what is a bad hedge and where hedging is not required.

Yesterday one of my subscribers mailed me this:

I need your help in one of the future transaction which was done prior to my subscription to your course.

I have purchased one lot of LUPIN – (AUG 2015 Future) at a price of Rs. 1751/- without hedging. Although for last 3 – 4 days it is showing up movement, I intend to cover it by selling 3 to 4 lots of PUT Strike price of Rs.1600/- presuming that it will not go below 1600/-.

May I request your help in the matter.

See the trade. This trader is in profit. Now he wants to make “even more” by selling not one but 3 to 4 lots of Puts on a strike where he feels the stock may not go.

Obviously my reply was: If Lupin falls – you lose money in BOTH Future AND Puts sold. Can you tell why are you doing this?

I am looking for some kind of answer like – I think Lupin will not go there (and I can make more money).

Hey you may be the best technical analysis guy out there or you may have a great sixth sense of the stock markets but there is no place for “I think”, “I feel” or “I hope” in the stock markets.

What if some regulatory news comes in and the Stock opens gap 15% down tomorrow? He loses a lot of money in both Futures and Puts sold.

This is the kind of trades people do and lose money. They do anything that they feel will happen or will not happen and when they lose money they complain that stock markets are nothing but scam where no one can make money. If you let greed and other emotions rule over over trading decisions then you deserve to lose. Do not blame the stock markets, blame yourself.

Best Hedge For Future

The best and very simple hedge for a Future trade is this:

Buy Future, Buy ATM (at the money) Put, or,
Sell Future, Buy ATM (at the money) Call

Both on the same stock and expiring the same day.

Of course there is a much better way to hedge futures in my course – there the hedge can sometimes overcome the losses in the Future trade and actually make a profit in the trade. If possible a hedge should have such capabilities.

Can you now see the grave mistake by this trader? You cannot have a trade where both positions either make money or loses money. A hedge is a trade that works exact opposite to the original trade. Like in the above example if Future makes money the option loses and if the Future loses money the options make. The loss in any case is limited.

The worst case scenario is when a trader actually ends up making a profit in such a dangerous trade and then doubles or triples the number of lots in the very next trade because he feels he has a great sixth sense to predict stock movements. This time the stock does not behave the way he wanted and he loses double the profits he made in the last trade. Should he then blame the stock? Unfortunately this keep happening for years. Why? Because hope has no end.

The trader then tries some other strategy – makes a profit, then makes a loss, changes strategy, makes profit, makes loss – the cycle continues. The trader keeps jumping from one strategy to another to find that one “golden” strategy that works. Years pass and nothing happens. Traders keep blaming their luck. Ultimately after years of trading their account show a huge loss.

Almost all phone calls I get have the same story.

In my view people who trade naked Futures (trading Futures with NO hedge) are the greediest traders. Tell me what does it costs to buy at least one at the money option for protection? If you think buying at the money is costly at least go for an option half the cost of the at the money. At least the trade will get some protection from unlimited loss.

What is a Real Hedge?

A real hedge is a hedge which makes sure the losses are limited and small.

For example if you buy a future and sell a call – and think you have done a great hedge – its wrong. Selling a call has a limited profit. After that the losses can be unlimited. So in my book that’s not real hedge.

Some people think selling a put is a great hedge against selling a call and vice-versa. When I asked this trader where is the hedge in this? This person was very excited to declare that since when one loses money, the other side makes – its a great hedge.

Its not because one can lose unlimited money while the other will only give a limited profit. Where is the hedge for the unlimited loss?

If you are selling an option you should buy another cheaper option to hedge.

I am Technical Analyst and I don’t need to Hedge

Real story: Four Gujarati brothers living in Chennai (yes Gujaratis live in Chennai too. 🙂 ) trade for a living. Each brother is given a certain amount to trade. This certain amount is not small. Each brother’s account is around Rs.75 lakhs. They have a WAR room (a room where all planning is done and strategic decisions are made) with latest computers, many trading terminals, large screen where stock movement can be seen, a highly paid software that gives signals to buy and sell to trade. In short the (unnecessary) accessories to trade must be worth 50 lakhs. Not to mention the monthly bills for trading software and other equipments plus the office space which again is not required. When I heard this obviously the first question I asked was how much profit he was making this year. For the first 6 months of this year his 75 lakhs account was down to 72 lakhs.

When I asked him what trades they take (though I knew what was coming) – he said they traded naked Futures.

Frankly trading Futures with no hedge and the account going down by just 4% in 6 months is a great achievement. He is lucky not to see a 50% drop which is quite common.

If you too trade Futures without hedge think about it. These brother have a world class infrastructure, latest trading software and computers which automatically generates trading signals – still they are unable to make even 1% profit in 6 months. How on earth are you going to make huge profits?

I told him one simple thing – why don’t you hedge? He was like – well what is that? I told him go back and track had you bought one Put for every Future buy and bought one Call for every lot Future sold then what would be the results today.

Unfortunately since they have done thousands of trades in the last six months it was virtually impossible to track all trades. However I can tell with guarantee the results would have been much better – possibly some profit. Because he lost only 3 lakhs, which means if the hedge was in place it would have severely reduced the losses while the profits would have been more or less the same.

So even if you are the best technical analyst in the world, you cannot do great without hedge.

Note: People who think buying costly trading software and other systems can bring great profits, think again. It is not the system that makes profit – it is what that has been fed in that system that makes profit. In other words system generates signals based on the algorithms made by the trader. If the traders’ thinking has flaws, the system will generate only flawed signals and you will never make money. And good traders don’t need machines. 🙂

Automated Trading is Getting Popular – Do They Too Hedge?

I don’t have much knowledge about automated trading, but I really don’t think they hedge. Here is the reason – most automated trading is intraday (day trading). In day trading it is the strategy and the discipline that takes precedence over hedging. Since hedging also involves paying for more brokerage, an automated system where human interaction is next to nil and does multiples of trades in a day, they do not hedge the trades. Automated trading is a system based day trading and highly disciplined trading with zero emotions – so hedging is not required.

Also please do not have the misconception that all Automated trading is the same. Its not. An automated trading works on the software controlling it. Company A may be trading in Futures with different set of rules while Company B may be trading in options with a different set of rules.

In the US even retailers can do automated trading. In India for retailer’s automated trading its banned. Some institutional investors do automated trading.

Verdict on automated trading is yet to come out, I am really apprehensive on this kind of a system.

In automated systems the trades are in and out in seconds, sometimes milliseconds. When you are in and out of a trade in seconds its scalping and not trading. Scalping is an art which is beyond the scope of this article but I will write on it some day.

Note that some people in India calls Scalping as Scrapping. Well Scalping is the correct word.

By the way, if you can practice and master the art of scalping, you can really make good money in stock markets day trading (intraday). 🙂

Conclusion

  • It does not matter how smart a trader you are, you should always hedge.
  • Day trading needs more discipline so hedge may not be required.
  • Automated trading is getting popular, they rarely hedge but since they trade mostly day trading and the system is very strong no hedging is required.
  • If you are a day trader and have an account with discount broker test your trades with both hedging and without hedging sincerely for 6 months and stick to the one that works best for you. Count in the brokerage expenses too.
  • If you are a positional trader, it does not matter if you use a system or are highly disciplined trader – you should hedge. PERIOD. Remember hedges saves you overnight when a bad news may come in.

    Anybody with real experience with automated trading may please write their views in the comments section. We will be really thankful.


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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.

    { 16 comments… add one }
    • S Bapi

      Dear Dilip Sir,

      Firstly I would like to thank you for helping people in doing well in option trade.

      I have visited to your site many times and also read many blogs from many people.

      I want to tell you about myself. I am working in a private firm and my salary is about 13000 rupees. I am new to the share market. I had gathered a little fund within a few months to invest. But all of my money was lost for trading.

      Now I am really hopeless and cannot understand what to do. I still have interest in markets. But I am not getting a way to learn about stock market or option market. When I lost everything, I understood that without knowledge or proper education I can never make money from it. So I would like to have a course or education regarding this. One thing I believe that for a better future aspect one should make money from this type of instrument. I usually watch TV channels like CNBC Awaaz and ZEE Business.

      Now please help me what should I do? I surfed internet and found so many sites since last month but in my view your site looks to me really best. Hope you will find a better path for me. I really want to do your course.

      Before doing your course what should be done by me so I can understand your course in a better way.

      Right now I do not have sufficient money to invest in this market. Again I am starting to collect money from my salary. After a certain time period I will start again. I don’t want to give up. Failure may occur but I don’t want to give up. That’s why this time I want to prepare myself before trading.

      Thanking you.

      • Bapi,

        Appreciate your thinking. From your comment it looks like you have not lost a lot of money trading. And now you want to educate yourself before taking the next step. Very nice. Read my blog, read other good blogs as well. Learn as much as you can. When you are clear with the basics of how options work – then take my course. It will help a lot.

        All The Very Best.

    • Vijay Kumar

      Dilip ji,

      The article is like ‘a Stitch in Time Saves Nine’.
      Hope everybody learns it fast.

      Vijay

      • Yes. No doubt I get quite a few emails where traders are stuck in a bad trade and need help. I don’t charge anything but I help. The problem is they will do that mistake again. Yes lets hope people learn it fast.

    • R. Nathan

      Dilip, I hope you can clear this up for me — Recently, SEBI increased the margin requirements for F&O which means that we’ll be required to have more capital to trade in this segment. So if I want to trade the strategies in your course, will I require much more than Rs.30,000 in my trading account, or is this capital enough to get started? How much capital would you ideally recommend a beginner have to trade your methods? Thanks in advance, and keep up the good work.

      • I think they have increased this on equities. Lot size band will be from 5 lakhs to 10 lakhs. So on equities you will need at least 50,000 to 1 lakh to trade F&O. Not sure what will be the exact lot size of Nifty. This will come in effect from October 2015. I will write a mail when time comes and I am very sure about the margin blocked. I am sure you can trade on Nifty with no more than 50,000 or 60,000. But, when you actually see returns do you keep only that much amount in your account?

        • R. Nathan

          I’m willing to allocate up 60-70k in the beginning till I get a grasp of how the F&O markets function. If things go right I’m willing to allocate more, as necessary. To be honest, I’ve never traded in equities and have been more into technical trading in commodities and a bit of forex. I’m looking to expand this base into equities with your course as a springboard.

          • Yes Mr. Nathan. That’s the way forward. If you take one step at a time the worst case you go back 1 or 2 steps back, but if you try to jump you may fall and hurt yourself. Start slowly with less capital and then speed up.

    • Vivek

      Hello sir,
      Today I read ur post in that u share ur views about Automated trading. U said that automated trading is ban in India but now days I heard many broking houses offering this service like Zerodha, mastertrustcapital, Traderjini etc. is this true? As per ur view its good to do automated trading than manual trading by applying good technical strategy. Sir, pls share ur views on automated trading & how can retail trader do this & how to learn this?
      Thank u…

      • Vivek,

        I never said automated trading is banned in India. I only said that it is not allowed for retail traders by SEBI. To do you need to register yourself as an authorized person to do automated trading. There is a cost of registration. Please look at the NSE website for that, though the cost is not too much.

        But I have always said that the strategy that you are going to implement in automated trading is what is the MOST important thing. If its a bad strategy it will lose money anyway – automated or not. If its good you need to back-test it to see if it really works. But I do not believe in back testing. A business that was great 10 years back may not be that good today. Same applies for any strategy. Problem is you cannot front-test. 🙂

        The strategy itself has to be good and if its positional then there is no need for automated trading. If its intraday and you are too busy (read lazy) to trade then go for automation. Remember that apart from registration there are other costs involved like software etc.

        More information here:

        http://zerodha.com/z-connect/charting-coding-and-backtesting/automation/automating-trades-getting-started

        • Vivek

          Thank u sir,
          for a very quick reply to my query. I am agree with u r comments. Actually I Read some information about automated trading thats why I asked u this query. In future I am thinking to do automated trading if I get good strategy for trading. As u said some softwares also required, I think like Amibroker, Automation, Data provider etc. softwares required. Sir on NSE where can I get information about automated trading, can u share nse website detail link of that pls?
          How can retail trader do automated trading safely? Sir u have know any strategy for this. I also heard that in other countries near about 90% of trading by automated trading. Is this true? If yes, then why not we indians also do this & earn some money by doing systematic trading without involving emotional approch because in trading retail trades many times loosing money by their emotions.
          Pls share u r views on this sir.
          Thank u….

          • Here is the link of automated trading on the NSE website:

            http://www.nseindia.com/technology/content/trad_tech_algo.htm

            No there is no data of the percentage of people doing automated trading in other countries. However only high net worth (HNIs) are involved in this even in countries like USA. Retail traders there too do manual trading.

            You are of the the view that just because systematic trading does not involves emotions – it should be profitable. Its not like that. It is based on a good strategy. Else nothing will work.

            • Vivek

              Thanks again sir for replying me. U r clear my many doubts about auto trading. I also read ur articles about ur option course. As u said u also plan to start one strategy courses in 1000 Rs. when u r starting that. I am also studying on straddle Long strategy from some time, its really work many time when volatility more. Is this good strategy for retail investor like me, pls share ur view sir…
              Thank u…..

              • Vivek, where I have told I will teach one strategy course for 1000?

                Long straddle is working now because the VIX is just not dropping – in fact increasing every other day. When things gets stabilized then you will lose money trading long straddles because VIX will start decreasing. Thanks.

    • marina s rao

      Dilip ji,

      Namasthe.

      Learning points from this post :

      There is no place for “I think”, “I feel” or “I hope” in the stock markets.

      Best Hedge For Future trade is this:

      Buy Future, Buy ATM (at the money) Put, or,
      Sell Future, Buy ATM (at the money) Call

      Both on the same instrument with same expiry date.

      A real hedge is a hedge which makes sure the losses are limited and small.

      Even the best technical analyst in the world, cannot do great without hedge.

      While selling an option buy another cheaper option to hedge.

      In day trading it is the strategy and the discipline that takes precedence over hedging.

      Learning points from replies to comments on this post :

      The strategy that is implemented in automated trading is the MOST important thing.

      A strategy that was great few years back may not be that good today.

      You can back-test but not front-test.

      Plz correct the following lines :

      In 3rd para under sub heading ‘ What is a real hedge ‘ :

      Some people think selling a put is a great hedge against selling a call and vice-verse.

      as

      Some people think selling a put is a great hedge against selling a call and vice-versa.

      This person was very exited to declare …

      as

      This person was very excited to declare ..

      In 5th & 6th paras under sub heading ‘ Automated trading is … ‘ :

      When you are in and out of a trade in seconds its scrapping and not trading. Scrapping is an art …

      as

      When you are in and out of a trade in seconds its scalping and not trading. Scalping is an art …

      By the way, if you can practice and master the art of scrapping …

      as

      By the way, if you can practice and master the art of scalping …

      ThanQ.

      M S Rao

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