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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). 🙂
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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