Saturday, July 19, 2008

Reducing Risk by Using Hedges

One trait common amongst all successful traders is the ability to manage risk. Experienced traders ask not how much money a trade can potentially make, but how much money a trade could potentially lose. Put another way, not losing money is more important than making money.

When I first started trading, I would usually bet all of my account on a single trade. I have learned (the hard way) that this is not a wise strategy. What I like to do now is go long and short different markets simultaneously in order to reduce risk.

As an example, for the past couple of weeks, I was long gold and short Canadian financials. I did this because the trend for gold was up, and the trend for financials was down. My plan was to hold on to these positions for as long as the trend persisted, which could end up being a day, or a year.

I got blown out of my financials short last Tuesday, but am still holding the gold position. Since I like to have a long and short position on at the same time, I decided to off set some of the risk in my gold position by shorting natural gas. I decided to short natural gas because the trend has turned down.

Being long one commodity and short another substantially reduces risk, but still allows for profit if one of the following three outcomes occur:

1) Gold and natural gas both fall, so long as natural gas falls faster
2) Gold and natural gas both rise, so long as gold rises faster
3) Gold rises and natural gas falls. This is the ideal scenario!

The following chart shows an ETF that tracks gold, GLD, divided by an ETF that tracks natural gas, UNG. If you are long gold and short natural gas, you want this chart to be rising:

As the above ratio chart shows, there are clear times when gold outperforms natural gas, and vice versa. Using this type of ratio charting can help you spot trends that are occurring beneath the surface, which I think allow for an opportunity to profit at a reduced level of risk.

For example, there are times where commodities will correct dramatically, and every commodity will be in the red. If we get one of these days, it probably will not negatively affect my account.

Again, the goal of this position is to remain long gold and short natural gas for as long as the trend persists. If the trend turns around, I will be out.

2 comments:

Anonymous said...

Hi!
I think you are right in the money here. I believe this will be a rather profitable trade. Just make sure you control your risk. I used to do quiet a bit of pairs trading a few years ago. Lots of fun and makes you think in different directions than normal. I mostly traded stocks within a sector and some merger arbitrage. Risk control is as always crucial!

Good luck and great to see you started the blog again. I read every post! ;)

Hakan
Sweden

Danny Merkel said...

Hakan,

Thanks for the comment. You are right, pairs trading does make you think in different ways.

So far its looking like gold and natural gas are both falling, but natural gas is falling faster.

I kind of feel bad shorting natural gas, since I think the long-term fundamentals for this commodity are so strong, but I have no choice but to follow the trend.