Five Ways To Hedge Against The Market Risks

In 2008, Warren Buffet had one of his worst year’s in the market. His portfolio declined by more than 30%. In the same year, James Simmons – who runs Renaissance Technologies – had his best year, gaining by more than 40%. In the past 20 years, the annualized returns of Buffet have been 20% while those of Simmons have been more than 40%.

The two are the most successful investors in our lifetime. However, their success and accomplishments have always been covered differently. This is because while Warren loves publicity, Simmons shuns it. In fact, out of Wall Street, not many people know him.

Their strategies are different. Whereas Warren Buffet buys stocks and holds them for decades, Simmons uses technology to initiate and terminate trades in what is known as high frequency trades. As such, every day, he initiates hundreds of trades. For the trades he expects to go up, he buys and sells the securities he expects to head lower. This is a good example of a hedge fund. Using this strategy, Simmons invests during choppy markets.

Please note that this article has educational/demonstrative purpose and should not be taken as investment advice.

As a trader, you can also practice the hedging methods used by Simmons. You can do this by following a strategy known as arbitrage, which is a method used to hedge against risks.

The first form of arbitrage you can use is known as risk arbitrage. In this, you buy and sell securities simultaneously. These are securities that have a track record of being correlated. For example, if you expect the dollar to be strong, you can buy the dollar index. To hedge against the risk of a weak dollar, you can buy emerging market currencies like the Turkish Lira or the South African rand. Historically, when the dollar rises, emerging market currencies tend to lose and when the dollar weakens, the EM currencies tends to rise. Therefore, in this case, by buying the dollar index, you might benefit if it moves higher and lose slightly with the EM trades. If on the other hand the dollar index falls, you might benefit by gaining in the EM currencies.

Second, you can trade the merger arbitrage in what is known as an event-driven strategy. When a company announces its plan to acquire another company, the stock of the acquiring company tends to fall while the company being acquired tends to rise. Therefore, when such a deal is announced, you can initiate such a trade and benefit from the differential in the pricing.

Another method of arbitrage is known as statistical arbitrage. In it, a trader takes a basket of underperforming pairs and another basket of overperforming pairs. Then, they initiate a trade where they short the overperforming pairs and buy the overperforming pairs. The hope is that these pairs will reverse.

Finally, there is a type of arbitrage known as triangle arbitrage. This is a type of arbitrage that happens when there is a discrepancy in the price of foreign currencies. It is usually done when a quoted market rate does not equal to the market’s cross-exchange rate. It therefore exploits an inefficiency in the market where a currency is overvalued in one market and undervalued in another one. In it, you exchange the initial currency with the second one, the second currency for the third one, and the third one for the first.

Another way to hedge against risks is to identify the safe havens and then buy place the respective trades. For example, in an upward market where the VIX is low, you can hedge against this downward risk by buying the VIX while still holding the trending instruments.

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