The Hedge—Trading Potential Profit for Lower Risk

A hedge is the purchase or sale of some instrument, usually not an asset, in order to protect against an adverse price move in a market in which we’re involved. A perfect hedge is a hedge that removes all the risk of adverse price movement. Wheat growers sell futures contracts and write call options as hedges against downward price movements in their market, and bread makers buy these same futures or write put options to lock in their cost of
the raw material used in production.

These are the two traditional hedges,and they can be perfect hedges against price risk in numerous cases. While we traders cannot usually apply perfect hedges in our trading, we can definitely reduce our risk in many instances by using similar tactics.In the general case for traders, a risk-reduction hedge consists of establishing a second position that is in some fashion opposite to our current position in a market.

Ordinarily, we use options as our instrument of hedge defense. If we own 10 July wheat futures and are concerned about a possible price decline, we might hedge the trade and provide some protection against such a drop by writing 10 July call options against our position. This is a common hedge, usually called a covered write. We might write only 5 calls and establish a partial hedge.

We might write 15 or 20 calls, typically somewhat OOM, and hedge with a ratio-write. On a different tack, we might buy some number of wheat put options to aid in minimizing the risk we’d incur if the wheat market moves lower. This is an insurance hedge and, as with all insurance, requires us to pay dollars out of pocket. Hedging tactics that involve option writing, contrarily, provide comparatively less risk reduction  but put dollars into our pocket.

All these are reasonable hedges, provided only that current market conditions and the expectation of the resulting position indicate their use at a particular time.When we trade pure assets, as opposed to trading assets in combination with options or options by themselves, the hedge is maximally useful if we apply it at the very start of the trade. If the (unhedged) asset price moves in our favor after entering a trade, we could write some appropriate options and put part or all of the trade’s open profit back into our pocket at that time.

This can be an inferior tactic in asset trades, though, because we might create the undesirable situation of having to stay in both parts of the trade until the options expire or at least until their time value has declined to a pittance,regardless of subsequent market developments. Hedging an asset trade after entering the position reduces our risk by some amount by definition, but simultaneously costs us a good deal of flexibility should the underlying asset price move unfavorably after we apply the hedge.

If the (unhedged) asset price has moved against our position, applying a hedge after entry is even less desirable. Why? For the same reason. To gain the full advantage that a hedge offers, namely, protecting against adversity and pocketing and keeping the premium on the options we write as hedges,we must remain in at least one part of our trade until the options expire or become worth only pennies.

If we buy 10 July wheat contracts at $3.02/bushel, taking a 14-cent risk and intending to hold them for, say, 50 days or until wheat reaches $3.30, and wheat thereafter declines 10 cents, applying a hedge at this point becomes downright dangerous. Suppose that, after this 10-cent drop, we write the July 300 call options for 6 cents apiece, and they expire in 40 days.

We’ve cut down our open loss in the position from 100 cents to 40 (excluding contest risk here, for simplicity), and that’s fine as far as it goes. It doesn’t go very far, however.If wheat moves lower still, our hedge actually creates a new problem for us. If we leave our original 14-cent stop-loss order in place and do get stopped out of our long position, we are now short unhedged, or naked, calls in a market that we thought was bullish only a few days or weeks ago.

Oof! If we’re not stopped out, we will constantly be in doubt whether to liquidate the entire trade and accept our loss or to sell back the futures and try to recoup some of the loss by waiting until the calls expire. Either decision might be correct, but in both cases we’re trying only to reduce loss, not to make a profit—because we have almost no potential profit remaining to us.

The maximum profit now available to us has shrunk to just four lousy cents per contract minus all the contest risk (when wheat moves above 3.04), and, speaking candidly, this situation is just awful. It’s also no way to succeed in trading.If we look at this trade from the perspective of expectation, what do we see? We entered a pure asset trade when we bought wheat futures.