103 Ways to Hedge Trading Risk

There are many ways to reduce trading risk through hedging. Funds typically employe multiple strategies to hedge trades. Similar to insurance, this safety net is available for many exchange-traded assets.

So to improve your trading, you need to understand how to protect yourself from uncertainty using these proven techniques.

Below is a list of risk hedging methods (with examples and tips) for multiple exchange-traded assets. Let’s dive right in.

PS: Don’t have time to read the whole list? Just get the cheat sheet and be reminded of updates.

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Stocks

Investors hedge stocks to offset the risk of adverse price movements.

Inverse Equity expand
inverse equity

Inverse Equity Description

A comparatively low-cost way of shorting the entire S&P 500 or other stock index is with an Inverse Equities ETF. These exchange-traded funds appreciate when the price of specific stock indexes falls in value.


Purpose: A way to protect your portfolio from major market disruptions.

Strengths: Using these instruments, you can avoid market loss and profit at a 1:1 ratio.

Considerations: The protection effect is minimal since full protection requires a 50/50 long/short allocation.


See Example and Rating

Buying Volatility expand
buying volatility

Buying Volatility Description

A more sophisticated hedge is buying volatility. As the market becomes more uncertain, so does volatility. Using multiple calls and puts options, one can go long or short in volatility. In effect, you are creating a wide margin of protection from directional movement.


Purpose: To protect seemingly stable positions from market shifts.

Strengths: This approach provides for a range of directional movements before a loss.

Considerations: The strategy is more complicated than is recommended for novice investors.


See Example and Rating

Put Options expand
put options

Put Options Description

A put option is a contract giving the right, but not the obligation, to sell or short a designated amount of the underlying security for a specific price within a set time frame. As a hedge, the put option protects against market downturns, usually for long positions.


Purpose: Like a short, puts increase in value if the underlying stock price declines.

Strengths: The maximum loss potential is limited to the amount spent while the downside protection is unlimited.

Considerations: The pricing for this "insurance" tends to be expensive.


See Example and Rating

Option Calls expand
option calls

Option Calls Description

Writing a covered call means you are selling someone else the right to purchase a stock that you already own, at a pre-determined price, within a stipulated time frame. As a hedge, your maximum upside is the value of the option.


Purpose: To protect against the decline of a specific stock or add to upside return.

Strengths: Regardless if the option is exercised, the cash premium is the sellers to keep.

Considerations: There is very little downside protection if the stock moves opposite.


See Example and Rating

Put Spread expand
put spread

Put Spread Description

A put spread involves the simultaneous buying and selling of options of the same type, puts or calls, and expiry at different strike prices. Investors will use a vertical spread when they expect a moderate move in the stock or index price. Depending on the type of spread deployed, the investor's account will either be credited or debited.


Purpose: To protect against moderate moves in the stock or index price.

Strengths: Since a put spread involves the sale of an option, the proceeds should offset the premium required.

Considerations: The profit potential in this strategy is capped.


See Example and Rating

Equity Collar expand
equity collar

Equity Collar Description

An equity collar is generated by selling an equal number of call options and buying the same amount of put options on a long stock position. It protects the downside risk of a stock position while limiting the upside potential.


Purpose: To protect the downside risk of a stock or index position.

Strengths: Little to no cost to execute.

Considerations: The upside or profit potential is minimal.


See Example and Rating

Fence expand
fence

Fence Description

A fence is a hedging strategy that creates a value band around a position to protect against market movements. It is a combination of a collar and a put spread providing a low-cost composition that shields part of the downside while allowing some upside.


Purpose: To protect against market movements - excellent for holding stocks that pay dividends

Strengths: Low-cost, downside protection, and upside allowances

Considerations: It sacrifices some of the underlying stocks upside potential.


See Example and Rating

Defensive Rotation coming soon
Delta Hedging coming soon
Sell Short coming soon
Convertible Bonds coming soon
Futures Hedge coming soon
Monetize the Position coming soon
Charitable Trust coming soon
Value Investing coming soon
Delta Hedging coming soon
London Bridge coming soon
Strips and Straps coming soon
Naked Calls coming soon
Arbitrage coming soon
Strangles coming soon
Forward Sale coming soon
Macro Hedging coming soon
Average Down coming soon
Contract for Difference coming soon
Straddles coming soon
Natural Hedge coming soon
Exchange Shares coming soon

 

Commodities

Investors hedge their commodities holdings as insurance from unfavorable changes.

Contract for Difference expand
contract for difference

Contract for Difference Description

This strategy is not allowed in the United States. The closest alternative for US Citizens are binary options.

Contracts for differences (CFD) is a trading strategy where the differences in the settlement between the open and close prices are cash-settled. In other words, investors use CFDs to make price bets as to whether the price of the underlying asset will rise or fall. With CFDs, there is no delivery of physical goods.


Purpose: Investors use these CFDs to speculate on the price moves in commodity futures contracts without having to purchase the asset.

Strengths: CFDs allow for potentially lower-cost asset shorts.

Considerations: Not allowed in the United States. CFDs use leverage with nearly unlimited risk.


See Example and Rating

Delta Hedging expand
delta

Delta Hedging Description

Delta measures the total exposure you have to the market, or product you trade. If you have a one put option contract with a 0.50 delta, you are "short 50 deltas" or -50 delta. Likewise, if you own 100 futures contracts for corn, you have 100 deltas.

Consider an investor owning 100 futures contracts for corn and two put options of 0.50 delta. What is the delta? If you said 0, you are correct.

The goal is to reach a delta neutral state to eliminate directional bias. A delta neutral trading strategy involves the purchase of a theoretically underpriced option while taking an opposite position in the underlying futures contract.


Purpose: To protect existing profit and shelter from adverse moves

Strengths: Delta Hedging is best for markets running up against resistance.

Considerations: The issues with delta hedging is the requirement to watch and adjust the positions involved regularly. Furthermore, it can incur trading costs as delta hedges are added and removed.


See Example and Rating

Risk Reversal expand
risk reversal

Risk Reversal Description

Risk Reversal, also known as a Protective Collar, is a hedging strategy to protect either a long or short position by using put and call options. It protects against unfavorable price movements at the expense of potential profit.

If an investor is short an underlying asset, the investor hedges the position with a long risk reversal by purchasing a call option and writing a put option. Likewise, if an investor is long, they short a risk reversal to hedge the position by writing a call and purchasing a put option on the underlying asset.


Purpose: To protect either a long or short position

Strengths: Risk Reversals offer good protection from market movements.

Considerations: The upside is limited by the two options.


See Example and Rating

Swaps expand
inverse equity

Swaps Description

An alternative to futures, Swaps are a hedging tool that involves two parties exchanging or swapping prices. It works by transferring a market price (floating) for a fixed price over a specific timeframe. Unlike futures, swaps do not trade on an exchange and are customizable.

A commodity swap is a derivative contract where two parties agree to exchange cash flows based on the price of the underlying asset. Used to hedge against price movements, they consist of a floating-leg and a fixed-leg.

The floating-leg is tied to an underlying commodity's market price while the fixed-leg is agreed upon by contract. The purpose is to provide the consumer of the commodity with a guaranteed price while the producer has protection from a decline in the commodity's price.


Purpose: To provide a guaranteed price for buying commoditys.

Strengths: Customized by contract writers and very good at doing its job.

Considerations: Swaps are an OTC transaction.


See Example and Rating

Macro Hedging expand
macro hedging

Macro Hedging Description

Macro hedging is a method risk mitigation centered around macroeconomic events—those large scale areas of an economy. Such activities include changes in inflation, unemployment, gross domestic product (GDP), or some other economy-wide phenomena.

While hedge funds utilize derivatives to take short positions against such events, retail investors can use Exchange Traded Funds (ETFs) for similar protection.


Purpose: To mitigate or eliminate large-scale economic (systemic) risk from a portfolio.

Strengths: Macro hedging can protect against market-wide threats.

Considerations: Macro hedging requires extensive study of economic indicators along with constant news analysis.


See Example and Rating

Futures coming soon
Back-To-Back Hedging coming soon
Forwards coming soon
Tracker Hedging coming soon
Strips and Straps coming soon
Straddle coming soon
Strangles coming soon
Box Spreads coming soon
Forwards coming soon
Cash Flow Hedge coming soon
Arbitrage coming soon
Cashless Hedge coming soon
Natural Hedge coming soon
Inverse Equity coming soon
Pareto Hedge coming soon
Proxy Hedging coming soon
Cross Hedge coming soon
Nonfinancial coming soon
Anticipatory Hedging coming soon
Bread Basket coming soon
Dynamic Hedging coming soon

 

Forex

Investors hedge Forex to offset or balance their current positions.

Short Long expand
short long

Short Long Description

Also known as a direct hedge, this strategy involves opening a trade in the opposite direction of your current trade. For example, if you are long EUR/USD, then open a short position. Likewise, if short, then open a long position.

It may seem counterintuitive as the net profit will be zero. However, it allows you to hold your current position while waiting for the trend to reverse. Otherwise, closing the trade means accepting a loss.

Not all Forex brokers allow this type of trade.


Purpose: To hold a position without loss.

Strengths: A direct hedge can reduce or even prevent loss due to market shifts.

Considerations: Not all Forex brokers allow this type of trade. The bid-ask spread could be a problem.


See Example and Rating

Currency Correlations expand
currency correlations

Currency Correlations Description

Currency correlation refers to the sensitivity of a position to market volatility. In this context, correlation is the measure of the relationship between the two currency pairs. Some of these pairs move together while others move in the opposing direction.

A strong correlation implies that when one of the currency pairs rallies, so does the other. For example, if EUR/USD and GBP/USD have a strong correlation of 0.95, then a move in one should mimic a step in the other. However, these correlations change over time.

The hedging strategy comes from understanding the relationship between the position you wish to hedge with its correlated counterparts.


Purpose: To protect a position from adverse market movements.

Strengths: A low-cost strategy suitable for all forex investors.

Considerations: Correlations change over time. Sometimes shorter than expected.


See Example and Rating

Multi-Currency expand
cash flow

Multi-Currency Hedge Description

A multi-currency hedge takes opposite positions on two positively correlated currency pairs. For example, consider a short position on EUR/USD. To hedge your USD exposure, open a long position on GBP/USD, assuming they have a high correlation. This strategy results in protection from the Euro falling against the US Dollar.

Unlike the direct hedge (short-long) that results in zero net profit, a multi-currency strategy makes it possible that one position might earn more than the other losses.


Purpose: To protect against adverse currency movements.

Strengths: A low-cost strategy that can perform better than a direct hedge.

Considerations: You may open yourself up to exposure due to side-effects.


See Example and Rating

Trading Volatility expand
volatility

Trading Volatility Description

Volatility trading in forex is trading the volatility of a currency pair's price movements instead of the price itself. Volatility is the measure of how drastically the market prices move.

A more sophisticated hedge is buying volatility. As the market becomes more uncertain, so does volatility. Using several calls and puts options, one can go long or short in volatility. In effect, you are creating a wide margin of protection from directional movement.


Purpose: To protect seemingly stable positions from market shifts.

Strengths: This approach provides for a range of directional movements before a loss.

Considerations: The strategy is more complicated than is recommended for novice investors.


See Example and Rating

Arbitrage coming soon
Interest Rate Parity coming soon
Put Option coming soon
Call Option coming soon
Covered Interest Arbitrage coming soon
Going Home Method coming soon
Fence coming soon
Delta Hedging coming soon
Forward Exchange coming soon
Futures coming soon
Money Market coming soon
Short Short Long coming soon
Roll Off coming soon
Zen8 coming soon
Martingale coming soon
Sterilise Positions coming soon
Macro Hedging coming soon
Direct Hedging coming soon
Risk Reversal coming soon
Dynamic Hedging coming soon
Hotel Reservation coming soon

 

Cryptocurrency

Investors hedge their crypto holdings to create a neutral exposure.

Perpetual Futures expand
futures

Perpetual Futures Description

A Perpetual Futures Contract is a futures agreement for cryptocurrency pairs based on the current market or spot price with no expiration date. Investors can hold a position until they decide to close it.

This derivative is a means to speculate on the price of a cryptocurrency pair without directly holding the underlying instrument. As a hedge, it allows one to protect their actual holdings from adverse market conditions.


Purpose: To protect current holdings from adverse market conditions

Strengths: Based on spot price instead of a future price

Considerations: Subject to market volatility


See Example and Rating

Crypto ETN expand
crypto etn

Crypto ETN Description

Exchange-Traded Notes (ETNs) are unsecured debt securities traded on an exchange like a stock. Similar to bonds, but do not pay interest payments. Also, they do not own the underlying asset.

For example, a Bitcoin ETN is a debt security that reflects the price of Bitcoin. Investors can trade the ETN, making money from gains or losses in the market. Otherwise, they can hold until maturity to get a return equal to the performance of the underlying asset minus fees.

As a hedge, an ETN gives investors the ability to buy a cryptocurrency position for far less than making the actual trade. Meaning you can protect current holdings by using the opposite direction ETN.


Purpose: To trade crypto price swings with less expense

Strengths: A low-cost means of protection current holdings

Considerations: Tax treatment may be different than crypto holdings and liquidity is a current concern.


See Example and Rating

Contract for Difference coming soon
Trading Volatility coming soon
Futures coming soon
Arbitrage coming soon
Diversifying coming soon
Forwards coming soon
Delta Hedging coming soon
Collars coming soon
Forex to Crypto coming soon
Short Short Long coming soon
Roll-Off coming soon
Fence coming soon
Martingale coming soon
Binary Options coming soon
Correlating Pair Hedging coming soon
Fence coming soon
Dynamic Hedging coming soon
Big to Small coming soon
Currency Swap coming soon
Silver Smith coming soon
Strips and Straps coming soon
Nonfinancial coming soon
Box Spread coming soon
Leveraged Puts coming soon

 

Now It’s Your Turn

So which strategy are you going to try next?

Are there missing hedges I should add to the list?

I reply to everyone so…

Let me know by leaving a comment below!



© 2020 Todd Moses

The strategies discussed are for illustrative and educational purposes and are not a recommendation, offer, or solicitation to buy or sell any currency or to adopt any investment strategy. There is no guarantee that any strategies discussed will be useful. Todd Moses is not a licensed securities dealer, broker, or US investment adviser or investment bank.