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What are Operational Hedges and how it is used to counter pullbacks

We are not buying Puts against portfolios, but we are intentionally selecting a set of strategies which can save us from any move that is surprising and is out of ordinary.

SHUBHAM AGARWAL | 20-Jul-19
Reading Time: 3 minutes

Once in every few months, there comes a time when things are going painfully in other direction of the consensus or what we call the market mood.

Amid the sequence of higher tops (uptrend) or lower bottoms (downtrend), the opposite starts happening or, even worse, it makes one big leap in the opposite direction and just stops making meaningfully bigger moves.

We are going to discuss how to best handle a situation like this. First of all, taking a hedge is most ideal and shall be inculcated as a natural instinct as and when there are extremes whenever we are in extreme fear (would kind of come naturally) or in extreme greed.

First, the underlying makes that big move to go 3 percent higher and, then, pulls back 1.5 percent. Suddenly, we see a fall of 3-4 percent. Initiate a trading action that is meant to hedge whatever trading positions we have, not restricting the upside profit potential but certainly hitting a break on losses after a certain level.

Just put a reference to the context. In the hunky-dory times recently, the kind of dent the budget Friday made could be taken as one indication that there could be a pull-back or a serious halt in the uptrend.

A similar situation could be on the downside as well, where we are trading a juiciest shorting opportunity. Suddenly, there is a violent move upwards piercing the recent swing high. Go ahead and initiate a trade correction mechanism.

This trade correction mechanism is nothing but Operational Hedges. What we mean by this is that we are not buying Puts against portfolios, but we are intentionally selecting a set of strategies which can save us from any move that is surprising and is out of ordinary.

A few things that have worked for me are listed below:

Partial Exits on Vertical Spreads:

Remember most of these pull-backs/respite from up/down trend could have a phase of consolidation. So, firstly, handle it by resorting to a vertical spread instead of Buying a Single Call or Put , Sell a lower Put or Higher Call against a Put or Call bought.

Secondly, remember there would be gyrations that could touch an unfavorable extreme before materializing your move. In that case, when a Bull Spread is executed, the stock hits its lower extreme, while the trade thesis still being intact.

Cut the Sold option leg as it has delivered its value and hold on to the Bought Option. This will augment the profitability optimizing the gyration.

Index hedge at all times:

Always have an opposite-facing (directionally) position in the index where a Bearish Strategy is executed where preceding trend was up and vice-versa. This will help us in cheering every opposite move, if not with the same joy, at least with a little smile as there is some compensation due to the index hedge.

Mix of Longs and Shorts:

Lastly, always in such times, keep a trading portfolio mixed of Longs and Shorts . In any market set-up whatsoever, there always is a pack of winners and a pack of losers. I don’t equally proportionate Longs and Shorts. But, post-budget, I had at least one Short against 2 Longs in the recent 11,500-11,800 range apart from a small index hedge.

Finally, tactics like these are nothing but an urge to be agile enough and adapt to every minutest mood swing in the market, thereby, taking some profit off of every market set-up possible.

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SHUBHAM AGARWAL is a CEO & Head of Research at Quantsapp Pvt. Ltd. He has been into many major kinds of market research and has been a programmer himself in Tens of programming languages. Earlier to the current position, Shubham has served for Motilal Oswal as Head of Quantitative, Technical & Derivatives Research and as a Technical Analyst at JM Financial.

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