to Stop or to Hedge, page-13

Hi Trae

Thanks for the reply. Apart from relating my own experience of this type of approach (and I'm by no means I'm saying the way I executed the strategy was perfect, in fact it was probably flawed), I was relating that experience to offer some perspective on the logic of the approach (so not necessarily on the execution) that you outlined in your original post to this thread.

Specifically, as far as I can see (and based on my experience of having tried it) the use of the type of hedging position you suggested rather than a stoploss offers no real advantage, and if anything introduces a couple of disadvantages. I will outline:

0. A directional position is entered which has a certain probabilistic outcome expectation (based on back-test, back-app, etc)
1. If the trade goes against you, taking the 5K SL locks in a 5K loss (i.e. it is realised in your account) as you say
2. Introducing the 5K hedge also still locks in a 5K loss, it just isn't realised in your account (because now you have 2 positions open)
3. If no other action is taken, the net trading position will remain in a 5K loss until some action is taken
4. If some new action is taken, i.e. entering an additional position one way or the other, using the same trading plan / setup with same probabilistic outcome expectation, then this additional action has theoretically no different outcome expectation and so it is entirely possible that all that happens is the net loss is compounded.

Take the following 2 possible cases:

1. An additional position in the same direction as the original position (let's say that was long) - now there are 2 x 5K positions long, and 1 x 5k position short - if the market heads down, the size of loss increases

2. An additional position is entered in the direction of the hedge position (staying consistent with case 1 this is short) so now there are 1 x 5K positions long and 2 x 5K positions short. If the market goes up, the size of the loss increases

In either case if the market goes in the direction of the 2 aligned positions, then ultimately break even will be achieved and if far enough then a profit.

Exactly the same outcome can be achieved by entering 3 separate and individual trades at the times when the above 3 positions were opened (original position, hedge position, and then additional position).

I think its easy to say sell when market overextends to the upside and buy when it overextends to the downside, but in practice it is not as easy as it sounds, at some point, i.e. at any point where an entry or exit decision is made, there needs to be a determination that the market will either go up or down. Using one particular trading plan or setup, the probabilistic outcome expectation is always the same (within the span of a few trades, over the longer run as history changes the probabilities may of course veer way way or the other).

Imo the more effective way to hedge is to use an instrument that is non-linear in response compared to the original instrument being hedged, for example shares in a stock hedged with options or futures, because they have a non-linear response over time and also as price moves closer to or further away from the market price.

Other than that, the simplest and most effective way of managing risk on any given trade is the stoploss approach. If its hit, move on to the next trade and add it to the statistics. If stoplosses are hit too often then it is better to look at the validity of the stats of the setup, or the stoploss distance (maybe too close) and adjust sizing accordingly.

Cheers, Sharks.