Rally Diary Entry: 

So I’ve got this approach in options income trading that I’m trying to hedge because it’s got a lot of risk on the downside but I just can’t find a hedging idea that doesn’t eat into its profits. How do I hedge effectively without zeroing out my portfolio or even taking away gains of my core trades?

Response from Anonymous:

Thanks for posting here and revealing your struggles with hedging. I think it’s an important subject.

Hedging has been one of the toughest things for me to figure out. Some people say hedges shouldn’t even be used because all they do is take away from gains. I’ve heard “experts” say that if you’re so worried about a position that you feel you need insurance then just don’t put on the position. But when it comes to trading you just never know what the markets will do so I think some peace of mind can go a long way. The problem is that if you don’t size your hedges correctly with your regular or main trades then they’ll eat away at your profits, like you’re saying.

So it’s really a matter of sizing. I think the most important thing to remember with hedging is that you want your hedges to lose. When your hedges lose that should mean your core trades are doing well or outperforming. So if you want your hedges to lose you have to size them so that you’re comfortable with the amount they’ll lose against what your core trades might make in scenario X or scenario Y. 

Another important concept is that a hedge isn’t supposed to be the big money maker in your portfolio. When hedges make money they really should only make up for part of the losses, unless you’ve got some brilliant way to hedge that always makes up for all losses but doesn’t take away from gains. I haven’t found anything like that yet and I don’t expect to find it.

There’s always risk in trading, no matter what strategy you’re running. Hedging, in my opinion, should just serve to give you a little peace of mind and not to erase all losses your core trades incur. There will be losses and you’ll just have to live with them. That’s the best advice I can give you on this subject and I hope it helps.