Day Trading 101: Strategic Hedging

Having the discipline to cut losers fast and let winners ride is a lesson learned in day trading 101. Yet even though the lesson is simple, it can be surprisingly difficult to employ when actually in a trade. Sticking to your trading discipline is particularly important when day trading because the market often moves irrationally on a day-to-day basis. Regardless of how calculated your decision to buy or short a stock for the day might be, the market may completely ignore your reasons and move in the opposite direction. Even if the stock does rebound days, weeks, or months later, you may have cut your losses before this happens.

Different Methods of Day Trading

There are a few different ways to keep losses small and put the odds in your favor. Three prominent notions to keep in mind when day-trading are these: keep your risk-reward balance in check, have confidence in the levels you trade at and use hedging strategies to protect profits.

Risk-to-Reward vs Cost Averaging Methods

Keeping the risk-to-reward ratio in check means that you will always make more on your “winners” than you will lose on your “losers.” With a three-to-one risk-to-reward ratio, you will allow a trade to go against you by only ten cents before cutting your loss, but are looking to make at least forty cents on your good trades. This way, if you are right only half of the time, you are still making money. Having confidence in the level that you pick to trade should be standard with every trade. However, if you choose to day trade using a cost-averaging strategy, it is absolutely critical. This method requires scale (either having a large bankroll or trading in small enough share amounts to create scale). Say you long a stock at a certain price after doing effective and thorough research and are extremely confident in the longer-term direction of the stock. Since day-to-day price movements may be unexpected, you can choose to lower your cost when the price goes down. This will increase the amount of shares you own while lowering the cost basis of the position at the same time. With enough capital, you can work your cost average to such a good price that when the stock does kick up, you can either exit the trade at a small gain or let the stock move up and reap well-timed rewards.

Hedging Your Trades

Another way to manage risk would be to long or short a stock and to simultaneously purchase an index that moves in the opposite direction. In order for this strategy to work, the purchased stock has to be more volatile (in terms of its beta) than the index you are hedging with. For example, let’s say you have shorted shares of Company X, which has a beta of 1.4. By purchasing the S&P index depository receipts (SPY), which have a beta of 1, you will still profit if the market, and Company X, go down proportionally because Company X will decrease more than the market. Yet if the market unexpectedly rebounds, your investment is mostly covered. 

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