Importance of hedging
What is "hedging" in trading? It is essentially using positions (trades) that will move in the opposite direction to other positions.
Example: you buy the S&P500, you are "long" S&P500.
If the S&P500 goes up, that's good and you make money.
If the S&P500 goes down, you lose money.
There are several ways to "hedge" this position. You can use options, you can diversify (buying other uncorrelated assets) and you can use "short" positions (selling).
For example, at the same time as you bought the S&P500, you can short sell another market, for example the CAC40 (French market). In this case, you build a "Long/Short" position: you are long S&P500, and short CAC40.
In general, the markets go up and down at the same time, that is to say if the S&P500 goes up, the CAC40 will go up, and vice versa.
The advantage of shorting the CAC40 (in this example) is that if the market falls, then you will gain on the short position, and this will reduce the overall loss on the S&P500.
The important thing in this strategy is to have the volumes right: if you bought the S&P500 for $1,000, then you will have to sell the CAC40 for $1,000, if you want the position to be completely hedged (let's not take into account volatility just yet).
Critics of this strategy will tell you: "OK, but if the market goes up and I win on the S&P500, I will lose on the CAC40 and it reduces my gain!"
Exactly. And that's the whole point of the strategy.
What you have to understand is the following: you have to think in RELATIVE terms. In other words, it doesn't matter if the markets go up or down, you have to find a market that will tend to outperform another market.
In our example, the scenario is that the S&P500 will outperform the CAC40 in the days/weeks/months to come.
So whether the global market goes up or down, by taking a long position (S&P500) and a short position (CAC40), we hope to make a RELATIVE gain.
Of course, you must have clearly determined which market you want to buy and which you want to sell, and why (ie. having done research).
Moreover, this strategy can be used in any type of market: stocks, indices, commodities, etc.
We can for example look at the difference between gold and silver, or
between oil and gas, or even between
gold and the S&P500. The possibilities are endless.
To do this, a precise strategy must be established based on a clear vision and thorough research.
What about you, how do YOU hedge your positions:
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