Cover yourself – what is hedging and how to use it

Most home traders head out into the markets uncovered.

I’m not talking about sitting at your laptop with no trousers on … (although I suspect many of us have checked the markets before getting dressed in the morning)!

I’m talking about taking unhedged positions.

There’s a misconception that hedging is a very cautious (and complicated) approach to investing … and one that’ll eat into your profits.

But the truth is that hedging is generally done by the most aggressive investors – the ones who want to stick their necks out in the markets, but want to know that they are covered if things don’t go to plan.

In that way, a hedged trading method gives you much greater flexibility to push the limits of what the market can offer.

Which is why hedging is standard practice among professional traders.

What is hedging?

Hedging means taking a second position that will offset price fluctuations in a first position.

It’s a kind of insurance policy, protecting us from things that might go wrong. Like insuring our homes … or fixing the interest rate on our mortgages …

But – unlike insurance policies – a hedged position doesn’t need to be a ‘cost’ to your trading, but can be a valid part of the money-making process.

While your home insurance might be protecting you against worst-case scenarios … the floods, fires, thefts we hope will never happen … a hedge on your trade is different – it’s protecting us from markets going in the wrong direction … something that any trader is all too aware happens regularly!

This means that a hedge has to work hard – and you need to know that you can pull in a profit either way.

How financial hedges work

Let’s say that you run a small airline, and you’re worried about the cost of fuel rising … by going long oil markets, you can hedge against this risk. If the price of oil goes up, you’ll benefit on the oil markets, while paying extra for your airline costs.

Or, if you run a dairy farm, and you’re concerned about the price you’re getting for your milk … By diversifying into an ice-cream manufacturing business, you’re able to take advantage of the low cost of milk.

It’s about mitigating risks, and turning a profit at the same time.

But I’ve never hedged before … why now?

While I’m aware that I’m reaching that age when, as a fully fledged ‘grumpy old man’, I confidently state that the world has gone to hell … that things have never been so bad …

… but it’s also true that there is a lot of flux in the world right now, with natural disasters … North Korea … unstable leadership … Brexit negotiations …

Add to that, a growing trend towards political grandstanding, with talk of overthrowing the status quo and tearing up the old ways.

Both these factors lead to high levels of uncertainty when it comes to deciding where to put our money.

How hedging helps

Hedged trading positions can cancel out these risks to a large degree. But, we need to find a correlated market – one that’ll react to the same kinds of events as the one we’re trading.

A tradition hedging method for investors in stocks would be to look in the same sector, and short a ‘weak’ company in the same sector that we’re buying a ‘strong’ company.

For example, if we’ve identified mining company ABC as a good buying opportunity, we could look around the mining sector for a company whose value will think will fall. We find mining company XYZ, which looks overpriced. Then we’ll buy ABC and sell XYZ.

Hopefully, both positions will make us a profit, but if some news comes out that causes a slump in value across mining stocks – we’re protected, because what we lose on ABC, will make up for on our short XYZ trade.

But this traditional model is struggling right now

There’s been a lot of talk in recent years about the fall in market correlation – meaning that individual shares in an index are ‘doing their own thing’ rather than just following the herd.

There are a number of reasons for this – mainly to do with low volatility, and the general behavior of bull markets. But the message for the hedge trader is that the balance between our ABC stock and our XYZ stock has become less reliable.

The answer is to move to a bigger picture … and hedge entire indices against each other.

And that’s exactly what Martin Carter’s DCG strategy is doing. Hedging the entire Wall Street index against the Frankfurt stock market, and having this built-in hedge allows Martin to take aggressive profits on these markets day in, day out.

Like last Friday’s trade, which made £254.40 … and Monday’s trade, which made £263.62 … and Tuesday’s trade, which made £271.01 … (based on a £10,000 fund) …

Added to earlier gains, this makes almost 10% profits (+£974) since it launched just 16 days ago!

Click here to get more information on the DCG strategy

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