@Quora: What is the point of hedging a portfolio instead of closing losing positions?

My answer to What is the point of hedging a portfolio instead of closing losing positions?

Answer by Laurent Bernut:

It seems like You are experiencing pain right now. This is clouding your judgment. So, let&s do a step-by-step approach’ 1. Emotional relief, 2. Boundaries, 3. Recovery 4. New rules

1. Emotional and Financial capitals: forgiveness and dissociation

You can recover from financial losses over time, as long as You recover from emotional losses. So, We need to get out of your emotional pain first.

The power of forgiveness

Village PeopleForgive yourself for losing money. Make peace with yourself. You made a bad a decision. It is alright.  In Jungian archetypes, this is called re-parenting the orphan. You soothe yourself as if You were soothing your child who got hurt. This is no new age fell good stuff: i am a professional short seller, not a cat lady.

There is solid academic research that links forgiveness and learning ability. Bottom line, if You beat yourself up, You create trauma and are statistically more prone to relapse. The Village People masculine approach  to taking losses like a man  may result in storing memories in the hippocampus (trauma, pain), rather than the pre-frontal cortex learning centre.

Dissociation

No problem can be solved at the level it was created“, Albert Einstein, patent clerk

This is a cool jedi trick. Put yourself in the shoes of someone You respect for her investing/trading skills. Really feel being that person. How would she react ? Would she be calm, composed ? Would she have slow or fast breathing ? Try to emulate this person both physically and mentally.

While You do that, exhale twice as long as You inhale, and widen your vision from tunnel to peripheral, look up a bit.

When You have impersonated this person, ask yourself how would this person solve the problem ? Take a pen a paper and write it down. Do not commit to memory. The chemical reconstruct we call memories are highly fickle and inaccurate.

This is a powerful exercise that frees up some mental bandwidth. Stress triggers the fight flight syndrome. This hijacks the prefrontal cortex and hijacks the thinking brain. This exercise frees up mental bandwidth. Practice often and You will be the iceman on the trading desk

2. Set boundaries

Mad Max

“Hope is a mistake”

Hope is a mistake“, Mad Max, Aussie philosopher

If You ask this question, it is probably because You thought this “soft patch” would go away and You would be back on happy street in no time. You ignored the signals and You got caught in a storm with a t-shirt, didn’t You ?

Stock repair strategies as we use in options world never really do the job properly and they cost a lost of mental capital. Bad idea. Same applies to your situation.

You were probably optimistic and failed to think about stop loss. You probably don’t believe in them and may buy into the “buy and hope” fairy tale. Well, the best car in the world would not even sell 1 unit if it did not have good brakes.

At this stage, You will have to decide a NUMBER of the loss You can afford to sustain. Not maximum pain, just how much can You afford to lose so that You can recover within 6 months ? Repeat the exercise and stretch the time horizon, 1 year, 2 years 3 years, 5 years etc. Stop when You come to the same number at various intervals. Focus on the recovery period.

This neat jedi trick invokes the “future self” and reframing: it focuses on recovery as opposed to pain.

Write that number down and commit now to liquidating everything if your losses reach that point. No negotiation, no investment committee, just out

The way to make it more acceptable is to tell yourself being right means following a process, being profitable is an outcome, not a process thought.

3. Recovery: two certainties in life: death and short squeezes

“There are unknown unknowns”, Great War Criminal

There is no way to tell how long a bear market will last. Forget about the talking heads, They did not see the bear coming, so they probably won’t see it go either

One rule of thumb about hedging: it gets expensive during sell off, so be patient. Wait for a squeeze to hedge. They come once a month. Politicians feel compelled to flap their mouth at regular intervals during bear markets… So, don’t worry, someone is coming.

When short squeeze comes do this:

  1. Reduce your exposure: reduce size of positions that stress You the most. Reduce until You can sleep if You are not mathematically inclined. You have to do it, it is part of hedging
  2. The smart way to reduce risk is to sell call against your holdings: You collect premium and reduce exposure
  3. Do not trade VIX options to hedge: this is for losers, amateurs and TV talking heads
  4. Long put spread: skew changes marginally during squeezes. So, this is time to put on put spreads. Put spreads are volatility structures that will make money if the markets fall between a ceiling and a floor. Risk is capped and so is profit potential. It is not very risky
  5. Don’t waste time looking for the golden fleece of safe asset class that does well in bear markets: The only asset class that fits this profile is cash.
  6. Avoid short selling yourself, delegate: short selling requires a level of skills that takes time and practice to mature. You should delegate this to a professional short selling manager.
  7. Be careful with selling index futures: Shorting S&P futures while being Long small caps it not a hedge. You are implicitly Long small caps and short large caps. Large caps fare better in bear markets, small caps get crushed. So, this feeling of being hedged is illusory at best

4. New rules

The best time to repair the rof is when the sun is shining“, JFK, Great XXth mystery

Hedging is like swimming lessons, It is a bad idea to think about taking swimming lessons when You are drowning.

The market is a joint venture between Murphy and Marcelus Wallace. Murphy makes sure that if something goes wrong it will. Then, Marcellus gets medieval on your a@#.

Bottom line: be prepared. Decide your hedging strategy before you put on a trade.

The best advice about position sizing I can ever give is: size your position not thinking how much you could make, but expecting them to fail and how much You can afford to lose.

What is better in the end, earning a little less than You could, or losing a lot more than You should ?

Good luck, and practice the first two mental exercises. May the force be with You


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What is the point of hedging a portfolio instead of closing losing positions?

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