Hedging 101 (Trading without a StopLoss)

Trading carries a huge risk for losses!
In fact, there is nobody in the world that trades who does not experience losses!
Our mission as traders is to limit the losses we incur so that we can protect our Equity.

As widely taught by educators, financial analysts, and other traders, the easiest way to protect ourselves from losses is to use a Stop-Loss order.

A stop-loss order will close your trade at a specific price set by you to limit the loss in case the trade becomes invalid.

However, there are a few drawbacks to the Stop-Loss:

• Stop-Loss orders are final! (they are good until manually canceled). Once the price is reached where the stop-loss order is, the server will execute a Market order (!!) to Sell or Buy Back the Item.
• Once the Stop-Loss order is executed, the loss or gain will be instantly added to or subtracted from your Account Balance.
• A Stop-Loss order is the same as a STOP BUY or STOP SELL Order, meaning they will be converted to Market Orders once the price has been reached and they will be visible in the order book.
• Large collections of orders (such as limit and stop orders) at a certain price building demand, and as we know supply and demand are what move the markets.
• In some sense, your Stop-Loss order does contribute to the fact that price actually goes there. (your own trade with its Stop-Loss order does contribute to “stop loss hunting” as this is just the natural reaction of Supply & Demand).

Another way of doing this is Hedging.

How to hedge instead of using a StopLoss Order?

Hedging occurs when a transaction is entered to reduce exposure to a prior trade turning against you and eliminating profits or increasing losses. Hedging is done to decrease the risks and hold a position until the markets begin to move in the original trade’s favored direction.

Let’s assume you are buying Gold and your analysis tells you that you are wrong buying gold at the current price once it falls by $2, so the logical place for a Stop-Loss order would be -$2 from the current price.

• Higher time-frame structure, however, would allow the price to fall even $10 without disrupting the structure of the market (eg. changes in trend).
• Instead of placing a Stop-Loss order at -$2 .. we place a Sell-Stop order of the same size our original trade has.
• Once the Sell-Stop order has been executed, remove Take-Profit and Stop-Loss from all related orders and trades.
• The price may move anywhere from here on out, but your Equity Loss will not change anymore.
• We will now wait for the price to fall to the -$10 point on the larger time-frame.
• Once the price comes back, close the Hedge Order at a small loss or small profit. and everything is back to where it was before.

Instead of realizing the Loss, we waited for the market swing out for a fraction of the cost.

What are the differences in costs?

STOP-LOSS Order:

• Realizing the Loss happens instantly on your Account balance.

HEDGE Trade:

• You will need to have double the Margin available to execute a Hedge trade.
• The spread of the new trade.
• Commissions of the Hedge Trade.
• Swap for both trades as you will be holding them much longer.

Lets Compare with a Practical example:

1. Assuming your account balance is $3000,
2. Risk per trade is 1%
3. Setup in question has a Risk to Reward Ratio of 1:1

StopLoss Scenario:

• The $30 Loss of will be deducted from your account balance instantly.
• Re-entering the trade once the price comes back, you will have to pay commissions and spread again.
• Once the trade played out as expected, you will have a winning trade of $30.

Hedge Trade Scenario:

• You will need double the margin to execute the hedge (approximately) as you have 2 trades running at the same time.
• The Hedge position will cost you another set of Commissions and Spread, and a possible Swap.
• Assuming the hedge is closed with a $5 Net-Loss and your trade plays out as expected afterwards.

Lets Sum things up:

The traditional Stop-Loss Order way resulted in:

• $30 Loss (by Stop-loss) + $30 Gain after re-entering the trade
• Total Gain: $0
• Total Loss: $0

The Hedge trade way resulted in:

• $5 Cost of the extra trade + $30 Gain from the original trade
• Total Gain: $25

 

Additionally, Hedging provides psychological relief, as the loss is stopped (for now), so you can spend time (hours or even days) to make up your mind, make a better plan and execute, or just close both positions on realizing that the trade was just wrong.
The point, however, is that you do not have to make this decision in real-time anymore, which removes the pressure and lets you do the good old “sleep over it” without being broke the next day.

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I can practically feel the trolls turning up the engines on this one… so here is a short disclaimer.

SwingFish does NOT provide any Advice in how to trade and how to manage your losses!
This category simply shows that there are other things you can do besides what is taught to you by the general public.
This post is to show the interested Trader other/alternative and cheaper ways to manage your risk and losses.