A Hidden Danger of Hedging

Let me save you from making this seemingly innocent but insidious mistake.

12/1/2020

12/2/20

12/3/20

12/4/20

I need to make a confession so my readers, and the future me, can remember this important lesson I had to learn the hard way.

I had a horrible time with a hedge on the Euro this past week because I started extracting profits from the hedge. The positive value accumulating in the hedge is a Siren's song to be ignored. It is a beautiful shiny Pandora's Box that will suck the lifeblood out of you if you open it. I'll explain.

I made a terrible mistake, but I didn't know it. I don't do a lot of hedging but when I got caught short on the Dec. EUR/USD as it took off on 12/1/20, I added a 1:1 hedge using the Dec. M6E micro futures. I didn't exit the trade because I had indications that this contract was going down and wasn't aware news had just come out that would reverse the bearish trend.

By the time my indicators said the short had failed, and I made the decision to hedge rather than exit, my position was already $500 against me. I went long 20 M6E mini's ($1.25/pt) to exactly counter the 2 EUR ($12.50/pt) contracts. This locked in my loss at $500 no matter how high the Euro went. Assuming of course I didn't mess with it. The idea was to let the Euro take this temporary ride up due to some unknown and spurious stimulus, like an institution needing some Euro's. Then when price started falling back to the mean, I would take off my hedge at the level I put it on, and when price came back down to where I entered the original trade, I would be whole again. I didn't have my news feed on at the time, so I didn't know the cause of the rise.

As the value of the hedge grew bigger and bigger I wanted to extract it more and more until I did, again and again. I didn't know what a huge mistake that was. It caused the "protected range"¹ to grow bigger and bigger, causing me to imprison myself at the pc to take off the hedge on any reversal, and then replace it at a lower price level. The bigger the protected range grew, the more important it was I catch the next down leg. And that market is open 23 hours. I was trapped like a home bound prisoner with an ankle bracelet. I literally didn't shave or shower or leave the house for 3 days because I had only an hour a day from 17:00-18:00 ET to cook, or any other time consuming activity that would take me away from the pc. I couldn't wait for the FX futures market to close for the weekend. 

Also, it is difficult to trade anything else because you must be ready to manage the hedge at any moment. 

¹By "protected range" I mean the locked in loss that the 1:1 hedge provides you. Originally it was $500. It soon grew to $2,500. Your loss is locked in because for every point your original core position loses, the hedge will gain one point. So your protected range depends on the value of your paper loss when you add the hedge. But if you exit the hedge to cash out the accumulated value, with the expectation you'll add the hedge back in at a lower price, but actually add the hedge back in at a higher price because the original price drop was a false signal, then you caused a loss, which diminishes the extracted value and therefore widens the protective range. Another cause for a failed attempt to extract value from the hedge is if you exit the hedge when it has a negative value because you think it has much further to fall, but it doesn't.

I would have been fine extracting the hedge profits, since its just in my trading account as cash instead of in the hedge, but the slippage and failed attempts in the entries and exits cause losses that expand the protected range. 

When many of the long awaited down legs appeared, for which I sacrificed many things, I missed them. Some were due to being asleep, even though the amount of sleep I allowed myself was quite limited. Some were because I had to temporarily focus on something very important and urgent. And the most maddening was just before a news event or a market close when I most needed a hedge. So even though I saw the price dropping and desperately wanted to take the hedge off, I couldn't because in a few minutes there could possibly be a dramatic reversal from the scheduled news event or over the 1 hour daily market closing, or over the weekend.

I'll survive the loss but I'm still stuck in this hedging hell at the moment. Mercifully I'm in the Dec. contract that will expire next week. If I'm still in this position then I'll be forced to liquidate and take the loss, whatever it is. I'll be so relieved, that the pain of loss will be significantly muted.

I've been studying the subject of trading for about 10 years and have never, ever heard or read about this phenomenon. Material on hedging, sure, but the necessity of fighting the psychological pressure of extracting value from the inflated hedge, never. You don't know what you don't know. Now you know.

Bottom line, once you put on a hedge, don't take the hedge off until the core position comes back within the protected range!