How to stay where you are without losing big

Back couple years ago, I started to explore ways to hedge risk when things is going to be risky. After some experimentation that costed me time and money, I started to understand more and thus the problem with it.

Hedge

Once a risk is discovered, trying to understand or minimize it is definitely a positive move. Therefore the strategy of applying hedge to your portfolio (or your project) is a common move.

You’d like to buy an insurance in case bad things happens in future period of time with some cost.

Practically I run into some serious problem with “period of time” and “some cost”, thus in turn, are new problems to solve. Normally we don’t like solutions with problem, unless the cost of applying the solution is much cheaper.

High cost

The cost associated with any hedge is that it still costs you something. And that cost is pure loss if bad thing never happen in the future. That’s why it’s an insurance, and you pay insurance premium for that potential benefits.

If this insurance only covers you one year or two or even lower, the cost would be too big to justify. Just take a look at how much you pay for your life insurance every year, yes that’s the life. Can your insurance offer you such low cost for that long? Most time, hardly.

If your insurance expires under a year, next year you have to roll this insurance again, it’ll cost you one more time for things that hasn’t happened. Add all together, you might be getting close to 100% of value that you hedge against. In that sense, adding all the cost together, you might realize it’s just not worth it, because the goal is to protect the original 100% as much as you can, not to consume it to zero.

High risk

Bigger issue is that it’s really hard not to get into the speculation if you are using hedge, especially when your position keeps changing. You might think you want to hold the position tight, however you never know when, why and where and how much you change it. If you are not careful, your hedged position will suddenly become speculation position, and the risk could become ten folds what you intend to do at the first place. You might consume 1000% of your current position. Not only you don’t meet the goal, you destroy the goal entirely.

Another risk related issue is that insurance protects average value. Suppose you have 100 people buying that life insurance, whoever older (or weaker) might take more benefits than younger guns. This is making sense, since the insurance model is aiming to make a smoother outcome for the overall group for overall period of time. So when you are facing a new insurance type, you need to find out if you happen to be at one end spectrum of that game. And if you are, then no matter how cheap the insurance, it might become worthless.

Paying extra premium is for minimizing the risk of having potential bad outcome, not to increase the risk of adding more bad outcome.

Hold Steady

Would that be simple, or let’s say cost effective, when you don’t want to move forward and start to think of moving backward, you just hold your position.

Let’s be honest, hold steady isn’t easy, and in certain situation, it’s not human either. Since we normally in the middle of some movement, and if we are forced to hold steady it could become very difficult if not entirely impossible.

However you have to think of the consequences when the best move is no move. Also don’t confuse no move with any of the following

  • not allowed to think
  • not allowed to talk
  • not allowed to experiment little
  • not allowed to do anything else

You can fill in the blank, basically you can do anything else, ex. eat, drink, run. I’m only suggesting you don’t act upon the situation for a period of time, an hour for the starter.

Stay Calm

Yes, I think you get the point, I’m asking us to stay calm. We didn’t create the situation, we are in no responsibility of lots of situations. Maybe you are, but you can’t be entirely responsible for everything. And most of time, somebody might or is going to do something to you, which is entirely out of your control.

Without hedge, how do we remedy the issue then? We are looking at 100% of our portfolio, to be honest, giving away some of them turns up to be the only cost effective solution. That’s where the experimentation should start, how about 1% first?

What if 1% is not enough to resolve it? Go with 5%, 10%, 20%, 40%, 60% .. You try it, trying also takes time, which is buying you more time as well, by the time you have to give away 50%, you already run out of lots of options, at the same time you tried a lot to protect the rest of 50%. This process can take as long as it takes, but as long as the process is still communicative or moving in the right direction, we should stay calm and continue this approach.

Giving away

Giving away is the model here, and it’s different than asking you to give up 100% right away.

You’d like to give away some gain for period of time in case bad things happens in the future.

You can see, the thing changed here is “insurance” that is replaced by “give-away”, and therefore their main difference are the following.

Give-away needs to happen now. So you can think this as anticipation of the bad outcome therefore committing to the less gain ahead of time. You might not even get chance to wait till the bad things happen. Of course bad thing might never happen either.

Give-away is not leveraged, you are giving away 1:1 of your gain, 5% is 5% which won’t be converted into 50% of the protection either. You pay for what’s worth. No more. If you happen to give away 50%, your final gain would be 50% less. Very easy to calculate (may not be very easy to accept).

Conclusion

Give-away or insurance, is more of your life style or philosophical view of life. There’s no right or wrong. And also depending on your experience with either, you might get different outcome. Relatively speaking, insurance is more suitable for well established and long term item, whereas give-away might be suitable for less established and short lived item.

Once again, life is short.

Front-end Engineer

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