Hedging is a common word in trading. However the risk management isn’t limited to the financial market. In a sense, I wish there’ll be a class called “Risk Management” in any school in the future. Of course, any field might already touch this topic, and we don’t use this word. Instead we use protection, insurance, or defense.
What is the hedging?
If you watch financial movies or read stories, you might be fascinated by those kool young guns that made a lot of money betting against a crowd and won. Yes, wonderful. But no, that’s not about hedging, that’s just normally referred as speculation in technical word. Wonderful, but you are not going to do it, aren’t you?
Hedging isn’t about making a lot of money. That’s for sure. That’s why the word risk management might be more proper to use, because it doesn’t carry that much of hype with it. But then you are like, really the hedging is about making less money?
Lame as it sounds, sort of, in the short term for sure. For the long term, it might give you the average of the supposed performance. What? So it never out-perform, well, that really depends on your definition of Out-perform.
Taking an example
Say you have 1 million dollars, you might lose them tomorrow. But now say you only have $10 to manage instead of 1 million dollars, does it make you a bit better? Of course with $10 it might be hard to make you a fortune tomorrow, but it’ll also make it quite hard for you to lose badly.
In reality, people might be more interested at the percentage loss or gain, since we could have the different level of tolerance for loss. Whoever manages 1 million dollars, in theory, should be able to get over with $100k loss. So $100k loss should be equivalent to the $1 loss to whoever manages $10.
Hopefully you get the point. Hedging, or risk management, is more about understanding your risk/gain(loss) ratio at a time.
Risk Ratio = Risk / Gain
Risk Ratio = - Risk / LossWhen speaking about your gain, if the risk is perceived to be high, you need to think about how to reduce this ratio; similarly, for a loss to be lurking out there, when the risk is perceived to be high, we want to try to loss less by decreasing this ratio.
For average person (IQ less than the top 0.1% smartest people in the world), the most effective way to reduce the risk ratio is to decrease the perceived gain. Because risk is a function of the gain, that’s what makes the risk ratio so intersting. Risk is never a constant, there could be lots of way to reduce it, I’m just stating the simplest way.
Making this simplest way even simpler, if you quit doing whatever you are doing (fold), your gain is zero (excluding the quitting cost), and your risk reduces to zero as well. This definitely isn’t the best move ever, but it’s not the worst for sure.
Just tell me how to hedge
Unfortunately I can’t teach you that. Partially because I’m not that experienced, partially because everyone’s tolerance is different. But I can do one thing, telling you what is the hedging in a more mathematical form.
Hedge = Eliminate the price fluctuation to zeroWhat? If the price change is 0, how do I make money?
Did I remind you at the first place, hedging isn’t about making a lot of money. Making a lot of money is called speculation.
But then how do I make money?
You make money as you always do, nothing changes the old or existing way of your making money. If the market bulls, you bet up, then you make money. Hedging hopefully does not interfere with that process.
Ok, so why do I need the hedge?
Yes, you can live without it if you have large tolerance to the change. For instance, when you loss $100k yesterday, you’ll still get to work and have a coffee and start the day as usual. You don’t need to hedge that $100k. You simply just lose it, because otherwise you’ll risk your potential gain if things happen to move in the positive direction.
To hedge or not to hedge
This is a million dollar question, but the answer shouldn’t surprise you.
Always hedge if you know how to and you think it worthwhile.
When you are young, you are afford to lose. But that can’t be used to justify to lose blindly so badly. You want to be young and smart, but not young and naive. If you know how to put yourself in a better position with some sacrifice of the gain, you should always do that. That is exactly the same reason your parents try very hard to not let you fall from the stairs. They could let you fall, but you could be dead. So what do the parents do? They let you have fun at the shorter stairs than the longer and scary ones, don’t they? Maybe that’s the hedging in front of us.
Summary
Hedging isn’t about making lots of money. Maybe hedging isn’t even about making money. Instead it tries to help you understand how to make zero money in the end for a period time. Why? Making zero money could be, or let’s say, should be better than loss a lot of money.
