How to Compute a Hedge (by mmTesla)

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This post will be dedicated to calculating your hedge using
the S&P 500 emini futures.

First order of business is to know how many dollars you are
up for the DAY. Let’s say for the sake of the example on Friday when the ES was
hovering on support around 1106 you were up an arbitrary number of $3,400
alright so from the close on Thursday which was 1124.5 and the current ES price
of 1106, is 18.5pts ES. $50 per point per contract so $925.

So we take 3,400/925=
3.67 contracts. When we used to hedge we liked to round down, and it is more of
a personal preference whether you would like to be slightly over or under
hedged. So if you chose to round up and used 4 contracts in this example and
decided due to how close we were to support, increasing delta, market internals
etc that you wanted to protect your gains. You would buy 4 contracts at lets
say 1106, and by the end of the day your hedge would have made
1119.5-1106=13.5, 13.5×50=675, 675×4=2,700. So instead of having 3,400 become
$700 in gains, you have locked in your $3,400.

As a general rule of thumb in this example IF you decided to
hold your hedge overnight due to fluctuating beta you would drop the 4th
contract and be holding 3. You can always drop your hedge pre-market, overnight
or during regular trading hours. So on one hand you are muting your gains but
that is a small price to pay for protecting profits, lowering risk and peace of
mind against gaps. When you hold overnight your hedge can be losing you money
but generally when the market opens your other positions will make up the loss.
But understand the risks of holding overnight!! Worst scenario would be you
held too much overnight and got a margin call because of some news that
happened while you were sleeping! So unless you know what you are doing don’t
hold overnight.

The other beauty about this technique in hedging is that it
allows you to practice day trading the futures for free. If the trade goes
against you, your other positions should make up the loss. So if you are net
short, then hedge by going long and taking every high probability signal to go
long. Worst that can happen in that scenario is the market continues down and
your other positions make up the loss. Although if for the flash crash for
example some stocks did not react very strongly to it so being hedged on the ES
could have hurt you. That however is an outlier event, that should be prepared
for.

NOW for the other side of this sword, some people will hedge
by chasing the market. That is a mistake because that will most likely lead to
you losing on your hedge and locking in muted gains. IF you plan on using this
technique I would recommend learning some day trading set-ups and studying the
flow of the futures market, and if it resonates with you practice hedging in
paper.

Anyways I hope this helps. I think Tim’s disclaimer also
covers his guest posters but if not, you are responsible for your own actions.

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