Saturday, April 07, 2007

Hedging isn't always better

Many of the strategies I wrote about in this blog are market-neutral strategies: long one instrument and short another one as a hedge. In many hedge funds, these are the only strategies that are allowed: investors imagine that only market-neutral hedge funds can deliver consistent returns in bull and bear markets alike, and the typically smaller drawdowns experienced by such funds allow them to obtain higher leverage from their prime brokerages. However, over the years I have become convinced that this bias in favor of market neutral strategies is misplaced in several ways.

First off, it is a bit silly to work hard to find a market-neutral strategy so that we can have a smaller drawdown so that we can increase its leverage to boost its return. After all these leveraging, the drawdown is often back to the same level as a long-only strategy! Why not just run a long-only strategy at a lower leverage, but that is often simpler in design and that incurs lower transaction costs (since there is only one-side of the trade to execute)?

Secondly, there is a misconception that long-only strategies will surely lose money in bear markets. This is probably true when you are holding overnight -- but long-only day-trading strategies are often profitable in both bull and bear markets.

Thirdly, there are strategies where only the long trades work. A simple example is a strategy that buys an index at its 10-day low, and exit when... well, there are multiple ways to exit and most of them work! If you try the mirror image of this strategy, i.e. short an index at its 10-day high, it works far less well. This simply reflects the positive mean return of the equity market, and why not take advantage of that?

Finally, related to the third point, sometimes the short hedge fails simply because the short instrument is actually quite different in nature than the long one, despite their superficial similarity. An example is provided by Mr. Sandy Fielden at Logical Information Machines. There is a usually profitable trade where you long a May gasoline futures contract and simultaneously short a May heating oil contract in the spring. The logic is that as the weather gets warmer, the driving season will begin which drives the price of gasoline futures up, and the demand for heating will decrease which drives the price of heating oil futures down. This hedged trade is supposed to eliminate general energy market risk. However, the weather is sometimes unpredictable, and in 2005, this trade went quite wrong primarily because the winter lasted longer. On the other hand, if you only enter the long side of this trade, i.e. buy gasoline futures in the spring, it works like a charm every year in the past 10 years! (I have posted a detailed analysis of this long-only gasoline futures trade in my Premium Content area.)

Therefore, if you trade for yourself and not for some institutions with a mandate only for market-neutral strategies, there is no need to be bounded by the same rules that they have to play by.


Unknown said...

Very good points Mr. Chan!

I recently discovered the Spring gasoline/heating oil spread (thanks to you pointing out the SFO article from January 2006).

I agree with your point, though one reason traders with smaller accounts actually might want market-neutral or semi-hedged positions is so they can easily (or more comfortably) put on positions in multiple markets, whereas for the layman trader, it is a little tough to balance a portfolio that contains many outright positions. For example, with a 100,000 account, holding 3 ES contracts on a Daily time frame will make your account pretty volatile. But I've been thinking that if I can add oil, grain, soft positions with the same amount of money via hedged / spreaded positions, I might obtain more diversification. I'm not an expert but this has been something I've been considering for some time now. Again thanks for the tip on the outright gasoline position being superior.

Ernie Chan said...

Hi Paul,
Yes, one needs to set a maximum net exposure for one's account. Beyond this maximum net exposure, one must hedge to avoid ruin. In the case of futures, if you want to be in multiple markets and has relatively small equity, it is hard to avoid exceeding max net exposure unless one hedges.

Another case where hedging is necessary is when one does not know ahead of time how many positions we will be holding as the day goes on. E.g. event-driven trading. Some quiet days, there is no need for hedging. Other days, hundreds of positions are created and one must hedge the net exposure as the day goes on.

Thanks for your great comments again!