Trading Journal #4: Risk Management (part 3)

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Note: this post should not form the basis for making investment decisions, nor be construed as financial advice.

In our previous post we discussed using various metrics for evaluating your performance versus the risk you take. So far most of our focus has been on single-sided trades: either you’re long or you’re short, and risk management has boiled down to position sizing and R:R ratios.

There’s much more to risk management, particularly when it comes to portfolio allocation. However, we’re traders first and foremost and as such are not focused on portfolio allocations, balancing, or resizing. We enter trades with a clear set of conditions, and leave the trade once those conditions are met or invalidated.

Another important aspect of risk management is hedging.

Hedging is the act of being exposed to multiple sides of a trade to reduce the risk exposure of a position. One of the simplest examples is holding spot while shorting futures of the same asset. For example, I could be somewhat unsure of what BTC is going to do next, so I decide to hedge: I may already hold some BTC, and then I open a short position such that I am ready for a movement in either direction.

There’s quite a bit to consider here, so let’s dive in.

Why would we hedge?

Hedging is particularly useful in times of exceptional uncertainty. Maybe an asset you hold is at an all-time high, it’s late in the bull market and nobody knows how much longer the party can continue.

This would be one example of a good time to consider hedging. By continuing to hold your spot position you are ready in case the price continues to rise, but if you simultaneously open a short position with a relatively tight stop-loss, you can minimize the damage to your portfolio should the price suddenly crash.

Hedged positions are rarely open for long periods of time (except when hedging against tail risk). Instead, they often act as counterweights when a position or asset starts moving further and further away from the mean, e.g. a mean reversion is expected in the not-too-distant future.

They are also useful in times of geopolitical uncertainty, such as the recent Russian invasion of Ukraine. A savvy investor would have hedged against soaring oil and natural gas prices before the official invasion date, as price volatility was highly likely should the invasion have actually happened (as it did). Another obvious hedge in hindsight would have been against the spike in grain prices, considering that Russia and Ukraine are huge grain exporters.

Of course, before the invasion ever happened most people were not expecting it to happen, as it seemed near-suicidal on Putin’s part, but here we are. Hindsight is 20:20, but before the invasion a smart investor should have at least been somewhat prepared should the invasion actually happen.

When should we hedge?

There are numerous ways one can hedge against uncertainty, volatility, and black swan events. However, since we’re focused on crypto we will continue to focus on this domain. For example, whenever an asset reaches a new all-time high there’s usually a lot of euphoria — “we’re all geniuses, and we’re going to the moon!” — but as demonstrated recently, new all-time highs can be lost faster than they happen.

In the most recent bull market, BTC topped out at around $65,000 in April 2021, before crashing more than -50%, only to push an new all-time high by November of the same year. Let’s take a look:

On 10 November, we see that BTC has touched a new ATH of roughly $69,000 (nice) before retesting the previous all-time high. Of course we know what happened next, but assuming we didn’t — this is a good example of a crucial inflection point: either the previous ATH acts as support and BTC bounces here and continues to run, or it isn’t support and we likely see it go lower in the short term.

This is an excellent scenario to consider hedging. If you’re holding spot BTC or have a long position, you have excellent conditions for opening a short here. Your invalidation is extremely clear (a new ATH above $69k) and you have many options for short, mid, and long-term downside targets.

In this situation, the short position covers any potential losses you may make on your spot holdings if the price goes down, and if BTC bounces and breaks another ATH your short position is closed and you can let your spot position ride (until another hedging opportunity arises).

We obviously know what happens next here, but this setup was perfect for opening a short. Even if your short position is on 1x leverage, any downside movement on BTC would have fully covered any losses your spot position made. As such, the only risk you were exposed to was the potential losses your short would have made if it had gotten stopped out — a roughly 7% loss on the short position.

Without the short, your downside potential may have been much higher, especially if you were letting the position ride with a wide (or non-existent) stop-loss.

How should we hedge?

There are countless ways in which a portfolio manager or fund may want to hedge against uncertainty. One of the simplest ways is to diversify your portfolio across a number of asset classes and industries. In trading, we are a bit more confined as we are mostly in and out of positions, without holding them open for long periods of time. That is, our portfolio is never fully exposed to assets and is based in cash most of the time.

Luckily, the narrow scope of our ventures allows us to be a bit more clear about our options. The first is of course to take an opposite position in futures, as described above in the BTC example.

Another is to purchase put option contracts with a relatively long expiry that allows you to sell your BTC at a (slightly) lower strike price than the current market price, giving you some flexibility should BTC go below the strike price of your options. It’s similar to a short via perpetual swap futures, but with a fixed expiration date.

Using options can be complicated for the average investor, and shouldn’t be done algorithmically. Instead, I’m using this as an example for the purposes of this article.

For most purposes, shorting via perpetual swaps is the easiest, most straightforward way of hedging a position. Make sure you live in a country that allows the trading of derivatives such as futures contracts, otherwise you’re stuck trading spot BTC.

There’s much much more to be learned about hedging, and for more information be sure to check out resources such as this to dive deeper than we did today.

That’s it for our Risk Management series! Stay tuned for the next post! In the meantime, be sure to follow our blog and social media, and check out our website for our upcoming launch.

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