Extremes are like a candy apple: very enticing but very painful to consume. Imagine a move that has crossed all consensus hurdles either up or on the downside and brought almost every contrarian to their knees in believing in the move and its longevity.
We would already be in uncharted territory in an upside move or a fairly longer-term low in a down move. Statistically speaking, these moves are outlier events with a limited probability of sustaining.
That brings us to the topic of today’s discussion. Given the fact that we do find ourselves into a move like that, where standing opposite to the ongoing trend is never a wise idea, but being prepared for that abrupt yet fierce reversal is crucial.
One should not start taking contra bets for sure but at least, it is a classic case for creating a hedge in the portfolio for a 'just-in-case' situation.
Pay a nuisance cost for a likely unforeseen scenario. Financial dictionary's adaptation of Hedge is ‘an investment to reduce the risk of adverse price movements in an asset’.
Opposite to the popular school of thoughts that associated hedges as a loss prevention mechanism, one should look at it more as a capital preservation mechanism by preventing further loss or locking accrued profits.
A hedge, when simply put, is an additional position that creates compensatory positive cash flows when the original position starts bleeding.
A simple example is life insurance, a hedge against death. But, more than what is a hedge, more important is to understand how and when to hedge.
Taking a hedge is most ideal and shall be inculcated as a natural instinct as and when there are extremes. Extremes can be defined as a scenario whenever we are in extreme fear ( which would kind of come naturally) or in extreme greed.
What is fear? Well, it is prudent for every trader to have a known loss strategy in the times of extreme pessimism, but convincing ourselves to do the same in the most hunky-dory times is difficult.
It is empirically proven that the house always wins, hence in most of the over-optimistic times, there is a possibility that while the entire participation is in the gung-ho mood, the market might have something entirely opposite planned for us.
Now here, not many of us resort to hedge maybe just because of the very first characteristic of hedging, it comes at an irrecoverable cost.
Even so, have a big heart and create a trade with a hedge alongside to safeguard the future.
Contract value (lot size * strike price)of Index Put options bought = 2-3 X portfolio value, has made sense for me a few times. However, many times the behaviour of a peculiar portfolio could be very different. Hence, try resizing and exiting, keeping this hedging as last resort.
Last but not the least, if it is about short options to be hedged, take a compensatory trade in higher call or lower put (OTMs) depending upon the position.
In case of an entrapment into options that have gone in the money, I would rather buy multiple of OTMs so that the adverse move can be reasonably compensated.
While if one is trapped in the long option position, restrict selling options 1:1 unless otherwise it’s the week of expiry and one can keep a close track of it.
(The author is CEO & Head of Research at Quantsapp Private Limited)
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