What Is Hedging?

Hedging is an act of risk management deployed to mitigate losses in some instruments by opening the opposite position in a related asset. Hedging is often involved in futures contracts in the context of the Vietnam stock market as the only instrument that allows investors to open short positions. Practically, hedging is a low-risk low-return strategy, in which the act of hedging will reduce the risk of losses but also limit potential gains. Hedging is vastly different from the concept of reversing position to get a huge pay off if the anticipation turns out to be right. 

Full hedging is the concept of neutralizing an entire investment portfolio in order to achieve a system beta close to zero. For example, if VN30F1M current price is 1300 and the equity portfolio of an investor is value at 10B then to full hedge the system, an investor needs to short the following number of contracts:  

10.000.000.000 / (1300*(100.000)) = 77 contracts

Partial hedging is the concept of neutralizing a part of a portfolio to reduce the overall system beta, but not necessarily all the way to zero. 

Why Hedging?

Sometimes, the risk and reward skewness can become tricky, and the risk factor is looming bigger in the whole picture. In such moments, traders may find that risk management becomes a much higher priority than potential returns. This is when a decision to hedge can be made. Though it is very hard to predict the future, certain events, such as market crashes, shifts in the economic cycle, or significant geopolitical and macroeconomic events, may indicate the need to prioritize safety over profits. Hedging then emerges as a strategy to navigate through uncertainties.    

Why Hedging Instead of Selling the Current Position?

First, the cost incurred in closing current positions outside of the pre-programming algorithm will be huge. It includes transaction cost, slippage cost, restarting cost. Restarting cost is the cost involved when traders decide to stop hedging.

Second, hedging using derivatives instruments will be much more reliable and faster. In the Vietnam derivatives market, liquidation is good and default leverage is usually very high, guaranteeing quick execution in any cases. For example, to liquidate a portfolio of 100 Billions in the Vietnam stock market at current price may need 9 trading days for a hedge fund manager. In the case of using derivatives, this can be done in 2 minutes to achieve the same effect with much less slippage cost.       

Third, hedging can be automated while selling current position is interfering with the current live running system and much harder to automate. A short position in an independent algorithm is very easy to deploy and maintain in the long run while selling a part of the current portfolio outside of a pre-programming system is a very troublesome task with the same reward. Also, data integrity will hold in the former case but not the latter case.

Recommend Approach to Apply Hedging

Algorithmic traders may need to recall that risk factors will never disappear. In fact, risk may be the origin of exceeding profits in comparison with non-risk financial instruments. Thus, in some perceptions, risk is not necessarily bad but vice versa. The concept here is which risk an algorithmic trader should take and which to avoid. Following is the recommended systematic approach to apply hedging in an algorithmic trading system.

First, algorithmic traders need to assess what type of risk there is in the current market. Is there a possibility that the market may drive the entire system toward a crash? For a positive beta system, there are many risks that algorithmic traders need to consider including geopolitical risk, foreign exchange risk, inflation risk, global recession risk, major war risk, margin call risk, and critical bankruptcy risk. In normal time, these risks are neglectable but when the risk is no longer small, protective measures, such as hedging, may be necessary.    

In case when hedging is necessary, algorithmic traders need to quantify system beta in each market scenario in normal cases. Then, the desired system beta in each market scenario needs to be formed. The difference in beta in both cases is the amount of hedging that needed.  

Opening short positions to hedge a full system beta is a critical step. And, closing those short positions strategy is also vital. When will traders need to close these hedging positions to operate normally? When will the hedging stop in the case of guessing right, wrong or nothing really happens? Traders must have a clear plan for the end of hedging before starting. 

Finally, it’s advisable to use a semi-automated hedging algorithm. In other cases, manual intervention with the system has to occur. At that point, once again, the system cannot operate smoothly and also the effect of hedging will be very difficult to evaluate afterwards.

In summary, hedging presents significant challenges due to the difficulty in accurately quantifying risks in a dynamic market with limited critical data. However, the potential reward lies in achieving a sustainable, long-term system - one that may be worth mastering.