A hedge is a trade that we enter in order to somehow offset an existing position. For example, imagine that we buy the 100 call because its implied volatility is cheap. However, this makes us synthetically long the underlying, so we sell some of the underlying short in order to mitigate our directional risk. This is a hedge.

But when should we hedge trades in general? We need to have an understanding of hedging concepts, so we can deal with the complexities that will occur in real trading situations. Ideally, we hedge all of the risks except those that we explicitly want to be exposed to. In practice this is seldom possible. Even most trades that we think of as arbitrages will have some minor difference in contact specifications. This exposes us to risk. Also common is the situation where a hedging instrument is available, but we have to weigh the benefits of hedging a risk against the costs of executing and managing another instrument.

There are a few situations where we should always at least consider hedging.

1. We enter a trade that has multiple sources of risk and we only have positive expectation with respect to one of these. Directionally hedging an option trade to isolate the volatility exposure is an example of this
situation.

2. Our position has grown too big. This could happen as a result of losses in other parts of your portfolio, or it could occur when one position performs unexpectedly well. If you originally wanted a position to account for a certain percentage of your risk, you should consider rebalancing
when it significantly exceeds this.

3. We can enter a hedge for no cost. For example, in times of market turmoil, it has sometimes been possible to enter long put or call spreads for zero cost or even a credit. This is a great situation. These spreads will probably be a long way out of the money. They have a low probability of making money. But they could pay off, and they cost nothing. It is like being given free lottery tickets. Such situations happen less often than they used to, but they still occur, particularly in pit-traded
products.

4 The hedge was part of the original trade plan. Sometimes we do certain trades because we are reasonably confident that an offsetting trade will present itself before expiration. In 1997, around 11 A.M. London time, a customer would buy several thousand 20 delta DAX puts in clips of one hundred. Once we had noticed this pattern we would have a few hours each morning to work at buying puts on the bid, knowing that our hedge would appear later. These situations occur frequently, and give market makers a significant source of profit.

How to take hedging decisions ?

All hedging decisions need to be made on the basis of a risk-reward tradeoff. And as soon as risk is introduced to a situation, personal preferences matter. What is seen as an unwanted risk by some traders will be welcomed by others. For a market maker, inventory is a source of risk that he will pay to remove, but for a position trader inventory is necessary to make money. But sometimes we just have a bad position.

Postion Sizing in Hedging

Part of the art of trading is recognizing this case and knowing when it is time to start again. In some types of trading this is all that position management is: merely a matter of knowing when to take profits and when to stop ourselves out of a bad position.

Option positions are far more complex as they present us with multiple risks. In fact the flexibility they offer us in being able to tailor our position to exact views of the market (for example, we might forecast that the underlying will rally slowly, both implied and realized volatilities will decrease, interest rates will remain stable, but a special dividend will be declared) can mean that we are complicit in getting ourselves into overly complex situations.

Keeping things as simple as possible is a good idea in most situations. Option traders in particular have a tendency to fall into the trap of overcomplication. So, no matter what our views are and how certain we are in their correctness, we need always to be absolutely clear what it is we are trying to achieve, when we will admit we are wrong and what we will look to do to adjust our position as circumstances change.

By definition, unforeseen circumstances cannot be predicted, however some contingency planning is
always possible and the more it is done, the more effective it will become.