Understanding the hedge direction on trading signals
One fundamental of signal trading is understanding the signal's hedge direction. The hedge direction helps the investor identify trade opportunities, capture upside, reduce drawdown, and generate alpha. Understanding how to apply the three most common hedge directions to investment signals will lead to higher returns and better risk management.
A hedge is a position taken in an investment designed to neutralize potential gains or losses. The hedge direction of a signal indicates which side of a trade (long or short) should be offset and by how much.
SYGNAL provides up to 3 hedge directions on any given instrument:
This article provides a detailed overview of the hedge directions found on most trading signals and outlines strategies for understanding, interpreting, and acting upon such signals.
The three primary hedge directions can be summarized as follows:
| Direction | Scale | Goal | Risk level |
|---|---|---|---|
| Long-Short | -1.00 to +1.00 | Alpha generation | Moderate to Aggressive |
| Short | -1.00 to 0.00 | Drawdown reduction | Moderate |
| Long | 0.00 to +1.00 | Upside capture | Moderate |
Note: one can trade Long-Short directions as simple Short-only or Long-only signals.
Long-Short - Hedge both positions
The most common and versatile investment signal, a Long-Short signal, looks at both the long and short sides of a potential trade.
Long-Short trading signals range from -1.00 to +1.00, where:
Max bullish
Bullish
Neutral
Bearish
Max bearish
The signal, sometimes referred to as the signal strength, falls somewhere within the above range and indicates to which degree the quantitative model is bullish or bearish about a given instrument.
An investor can trade BOTH the long and short sides, OR only the long or short side of a Long-Short signal. Determining which side to trade depends upon the manager's investment goals, risk appetite, starting position, and the ability to short-sell a particular asset.
The following strategies illustrate four means to implement a Long-Short trading signal.
Strategy 1: Trade long-short signals
Goal: Aggressive alpha generation
By far the most aggressive (and lucrative) application of a Long-Short signal, this strategy aims to generate alpha by trading both sides of the signal. The tactic assumes that the investor can short-sell the traded instrument.
When a signal is positive, the manager takes a long position in the target instrument relative to the signal's strength. For example, with a singal of +0.50, the investor would buy the target instrument using 50% of his assets (base) allocated to this strategy. For negative signals, the investor short sells the target instrument relative to the signal's strength. Signals of 0.00 are considered neutral and take no position.
To illustrate, imagine you are investing in S&P500 futures (target instrument), traded against the USD (base instrument). Your starting position would be 100% invested in USD. The degree to which you buy or short-sell the target instrument would therefore depend upon the Long-Short signal's strength.
Scenario:
| Target instrument | Base instrument | Starting position | Trade signals |
|---|---|---|---|
| S&P500 | USD | 0% S&500 100% USD |
-1.00 to +1.00 |
Signal Strength:
Positions:
| Instrument | Position | |
|---|---|---|
| Target | S&P500 | 0% None |
| Base | USD | 100% |
Use the slider above to view how to allocate assets as the signal changes.
In sum, as the signal becomes bullish, the S&P500 position is increased proportionally. When the signal is neutral (0.00), the trader will hold 100% of total assets in USD. As the signal falls below 0.00, the user will short-sell the target instrument (S&P500), proportionally reducing his USD holdings.
Strategy 2: Trade long-short signals without short-selling
Goal: Aggressive alpha generation
In cases where investors cannot short-sell, this second strategy still allows the manager to trade both sides of the signal aggressively, however, with a slight variation to the starting position: 50% long in the target instrument and 50% of the remaining total in cash. As the signal becomes bullish (positive), the target position proportionally increases. As the signal becomes bearish (negative), the target position gradually reduces.
This strategy is best employed by experienced traders who do not want to or cannot short sell the target instrument.
Because this type of trading is more common in forex, we will use a EURUSD FX signal as an example, with a starting position of 50% EUR and 50% USD.
Scenario:
| Target instrument | Base instrument | Starting position | Trade signals |
|---|---|---|---|
| EUR | USD | 50% EUR 50% USD |
-1.00 to +1.00 |
Signal Strength
Positions
| Instrument | Position | |
|---|---|---|
| Target | EUR | 50% |
| Base | USD | 50% |