Removing the pain from hedging
Playing the markets is a game where money is the final score, so it makes sense that traders tend to think that profits and losses are all that matter at the end of the day. But how we frame our trading can be just as important.
For example, research shows that people can accept costs but have a severe reaction to losses. This idea is explored by Daniel Kahneman in " Thinking, Fast and Slow ." From an emotional perspective, we feel the negative effects of losses more than the positive effects of gains. But we don't have that reaction to costs.
This is easily seen when it comes to option trading, especially with hedging. We see it as a loss when a hedge loses money, but we don't look at the cost of insuring our house or car the same way. We may not like paying these costs, but they don't take an emotional toll. (However, it is important to note that we do have an adverse reaction if we lose that house or car and do not have any protection in place.)
If we view our hedges as regular trades, then we will see losses when they go against us. That puts us in an emotional bind, as we can't make money on our long positions and hedges at the same time. Unfortunately, distress at the losses from hedges leads most investors to give up this protection altogether--often at the worse possible time.
Investors, including big funds , tend to give up on hedges as markets rally. They then have to buy them as markets fall, usually exacerbating the inevitable surge in volatility that comes with a selloff.
So we should condition ourselves to think of hedges as insurance. That way, there are no losses--only costs.
Option trading in general tends to lend itself well to this viewpoint, as we can consider the purchase of premiums as a necessary cost of doing business. After all, we are paying for the potential to profit if the underlying moves in the right direction.
This logic can be applied in many cases, but it behooves us to keep things in proper perspective. The $1 cost of a lottery ticket could also be considered a cost, for example, but that thinking would defeat the purpose of this discussion.
Here's another reason to take the subject seriously: Those who let emotions get the best of them often stop following their rules or plans. As a result, they frequently overtrade, make poor decisions, and lose money.
So changing the way we look at hedges can make us better traders, as well as help us sleep better at night.
(A version of this article appeared in optionMONSTER's Advantage Point newsletter of Sept. 24.)
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