Pairs Hedging

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In today's video, I want to talk about pairs hedging. When I’m looking to place new or adjusting trades or hedge trades, I will often use similar or correlated underlying stock to hedge other positions in the same sector or industry.

Now, this is a little bit different than what we talked about when we mentioned in some other videos about the fact that you should have uncorrelated securities in your portfolio. And that holds true.

You don't want to have too much oil stocks or ETFs, too much financials or social media or utilities. You want to have a lot of different securities in your portfolio because you want to be diversified across the market.

But when it comes to specifically hedging individual trades and if you're looking to make an adjustment or a hedge, sometimes I won’t make an adjustment to that actual trade, but I’ll make an adjustment that I would make in that trade, another correlated or related industry or sector stock that it's trading.

For example, if I have a position in RIG which is RIG and it’s an oil related security, then I could use that to hedge another position in USO which is the US oil fund and ETF. Again, if I have GLD which is a gold ETF, I can use that to hedge another gold ETF which is GDX.

If I have a Facebook position, I can use that Facebook position to hedge something in TWTR which is Twitter. You can see that we’re using very similar or underlying stocks to hedge some of our trades.

In this video, I want to walk through how we can do that with a current position that we have in HAL which is HAL (it’s Halliburton and an oil related stock) and how we can use XOM which is Exxon Mobil as a hedge for this position.

On our broker platform here at Thinkorswim, you can see I’ve opened up this trade here in Halliburton, and we had sold a credit call spread above the market that's currently a little bit against our position.

The stock is rallying a little bit. We have the 44/45 call spread above the market, and the stock right now is trading at almost 41, so it’s starting to lose just a little bit of money. We’re down about $19 on this trade overall.

If I wanted to go ahead and hedge this position, the first thing that I need to do is figure out just what are the Deltas of this position. I can see here on my chart that I’ve got a Delta of this position of -12.82.

What this means is that I need Halliburton to go lower for this position to stabilize. And that makes sense because I’m selling a credit call spread above the market and for me to make money, the market has to stay below my short strike which is the 44 call.

That makes sense that my Deltas are negative right now. If I want to neutralize this position or try to hedge it, I need to look for something that has some positive Delta to counterbalance this negative Delta that I have.

Now here's the problem. How do I know how much Delta Exxon Mobil has about HAL? They’re not exactly correlated, but they’re in the same industry, so that's good enough, but I need to know specifically how much of Exxon Mobil I need to trade to hedge this position in HAL.

Now, one of the ways that we can do this is with what's called Beta weighting. Right up here inside of our portfolio, we checked the box for Beta weighting. And in this box here, we can hedge any of our positions below to whatever symbol we put in this box. In our case, we’re going to just type in XOM.

And what that does is that now is going to Beta weight all of these positions to Exxon Mobil, so it’s going to relate everything and make them correlated to Exxon Mobil. And now you can see that the Delta of this position has now changed to -10.26.

That means that as it relates to Exxon Mobil, this position would need to have about 10 positive Deltas in an Exxon Mobil trade to hedge it. Again, this Halliburton position has now been converted apples to apples to compare with Exxon Mobil. Now what we need to do is find a position that has 10 positive Deltas.

Now what we’re going to do because one of our first adjustments to a credit call spread is to sell the corresponding put spread below the market, is we’re going to go out to Exxon Mobil here, and we’re going to go to the same contract month.

We’re dealing again right in Exxon Mobil. It’s currently trading at 92.5. We’re going to deal them the same contract month as our Halliburton trade, and we’re going to sell a put spread below the market, trying to get somewhere around 10 Deltas.

In this case, we’ll just start off with the 85 and the 82.5. And you can see that selling that put spread right here gives us an extra $31 credit which offsets some of the loss that we’re starting to see in Halliburton.

And more importantly, right here in the Analyze tab, you can see that the Delta of this new position is 5.49. This is only doing a one lot position; we have a 5.49 Delta.

Now, that is going to hedge part of the position, but remember, going back to our monitor tab, we need a Delta of about 10 or a little over 10 to completely neutralize or protect this position.

Here's what we need to do. We need to sell one more additional spread in this trade. I just moved the quantity up to 2, and now by doing that, you can see that the Delta is a little bit higher, but it’s never going to be perfect, it’s about 11 positive Deltas.

If I were to make this trade, this would almost exactly hedge this position and re-neutralize the Deltas by using Exxon Mobil as it relates to Halliburton.

The big benefit to doing this is that I’m sometimes able to get much better pricing on something in a corresponding ticker in the same industry like Exxon Mobil or USO or GLD, plus this also increases the level of diversification among stocks in our portfolio.

Now, we don't have additional positions in Halliburton, now we have that position split, and it’s Delta neutral, but it's across two different stocks that are in the marketplace that is very similar correlated.

It increases the level of diversification in our portfolio and the number of trades that we make. Hopefully, this has been a helpful video.

I know this is a huge topic that most people ask about. If you have any questions or comments about pairs hedging, please ask them right below in the video lesson section. Until next time, happy trading!