When Hedging Is More Practical Than Reducing a Position

Summary

The document compares hedging with cutting a position as ways to manage risk. Its central point is that reducing exposure may not be practical when the market is illiquid, as can happen with exotic derivatives, or when a position is too large to unwind quickly without affecting the market. In those situations, a hedge can reduce risk while retaining the original position.

It also notes that reducing a position may be less profitable than trading out of it. The discussion is brief and gives no quantitative comparison, worked example, or guidance for choosing a hedge. It does not examine hedge costs, basis risk, liquidity in the hedging instrument, or the possibility that a hedge itself is miscalculated. The choice therefore depends on trading constraints and risk tradeoffs that the document does not evaluate.

Key ideas

• A trader may be unable to reduce a position quickly when the market is illiquid or the position is very large.
• A hedge can lower risk while keeping the original exposure in place.
• Reducing a position may forgo potential trading profit.
• The document offers no quantitative rule for choosing between hedging and reducing exposure.

Tags

# Is it better to hedge or reduce the position size?


# Is it better to hedge or reduce the position size?












Traders hedge to reduce their risk. However, wouldn't reducing the position achieve the same results while keeping the risk management process simpler? At least, one need not worry about making the wrong hedging calculations.

What are the pros and cons of each approach?

## Answer by luckylwk (score 2, accepted)

https://quant.stackexchange.com/a/9102

You may not be able to reduce a position. Either because there is no liquid markets (for exotic and less transparent derivatives markets) or your position is to big to reduce at once (if you take on big positions versus an institutional client (e.g., pension fund) you may not be able to go to the market to reduce it all).

Plus, the whole point of trading is to (facilitate clients and) make money. Reducing positions is less profitable than trading it out in general.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.