Hedge Direction

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 to 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 that is designed to offset potential gains or losses. By extension, the hedge direction on a signal indicates which side of the trade (long or short) should be offset and by how much.

SYGNAL provides up to 3 hedge directions on any given instrument:

• Long-Short: Generate alpha
• Short: Reduce drawdown
• Long: Capture upside

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 major hedge directions can be summarized as follows:

Important to note, Long-Short directions can also be traded as simple Short or Long-only signals, and are thereby the most versatile and common hedge direction available on SYGNAL's marketplace.

Long-Short - Hedge both positions

An investor can trade BOTH the long and short sides, OR only the long or short side of an 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 an Long-Short trading signal.

Strategy 1: Trade long-short signals

Goal: Aggressive alpha generation

By far the most aggressive (and lucrative) application of an Long-Short signal, this strategy aims to generate alpha by trading both sides of the signal. The tactic assumes that the investor has the ability to short-sell the traded instrument and is best employed by experienced traders.

When a signal is positive, the manager takes a long position in the target instrument that is relative to the signal's strenth. 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 no position is taken.

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 strengh.

Use the slider below to view how the assets are allocated as the signal changes.

In sum, as the signal becomes more 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 an instrument (i.e most crypto assets), this second strategy still allows the manager to aggressively trade both sides of the signal; 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 is proportionally increased. As the signal becomes bearish (negative), the target position is gradually reduced.

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.

Use the slider below to view how the assets are allocated as the signal changes.

In other words, as the signal becomes more bullish, the EUR position is increased proportionally. When the signal is neutral (0.00), the trader will hold 50% of total assets in EUR and 50% as USD. When the signal falls below 0.00, the manager will progressively sell the target instrument (EUR).

Strategy 3: Using an Long-Short signal to trade the Short position only

Goal: Reduce drawdown

A less aggressive strategy, this scenario assumes that the trader already holds a position in the target asset, and wishes to reduce exposure as the price falls (drawdown reduction). In this case, only the negative signal values (0.00 to -1.00) are traded, while positive signal values are ignored.

This strategy is best employed by managers who already have an exposure to a given instrument.

For example, assume that the investor already holds stock in Apple Inc. (AAPL). Trading the short position allows the trader to reduce his exposure as the price drops and thereby decrease downside risk. Use the slider below to view how the assets are allocated as the signal changes.

Notice in the above widget that as long as the signal is positive, the trader continues to hold his long position. As the signal moves below 0.00, he progressively reduces his exposure to Apple until the signal hits -1.00, when he will be completely out of the market.

Employing this strategy allows investors to manage risk and reduce drawdown when the signals turn bearish.

Strategy 4: Using an Long-Short signal to trade the Long position only

Goal: Increase upside caputure

Trading the long position only can be interpreted as a buy low/sell high approach. The goal is to increase upside capture by increasing exposure to an asset as the market rises, and decrease this exposure as the market falls. To do so, the trader only trades positive signals (0.00 to +1.00) and ignores negative trading signals.

This is the least risky way to trade an Long-Short signal and is best suited for less experienced traders, or for experienced traders looking to time market entry.

To illustrate, let’s again take the example of investment signals using S&P500 futures vs. USD.

In the above example, the trader ignores negative signals, and only enters the market when the signals become positive. Exposure is then proportionally increased as the investment signal grows more bullish

Short signal trading

Less common than Long-Short signals, Short-only trading signals focus on reducing drawdown on positions which are already held by the asset manager. Short signals fall on a scale ranging from 0.00 to -1.00, where 0.00 is neutral, and -1.00 is max bearish. There are no positive signal values for Short signals.

To better illustrate, let’s use the example of Tesla Inc. (TSLA), overlaid with an Short signal. The idea here is that the investor already holds Tesla stock, and wishes to reduce losses as the price drops. The starting position is therefore 100% invested in Tesla, against a base currency (USD in this example).

In the above example a signal of 0.00, implies that the trader should remain 100% long in this position, while a signal -1.00 means that he should have zero exposure to Tesla.

A manager can also use an Long-Short signal to trade long positions, as explained here.

Long-only signal trading

Long signals focus on upside capture (buy low/sell high) trading strategies, and are useful for timing market entry and identifying opportunities. Short signals fall on a scale ranging from 0.00 to +1.00, where 0.00 is neutral (don’t enter), and +1.00 is max bullish.

As an illustration, imagine a scenario where an investor holds 100% of his assets in cash and is looking for an opportunity to invest in a particular instrument. Our trader has been following Chinese stocks in general and Tencent Holdings Limited (700:HK) in particular. He will use an Long signal to time his market entry, buying in when the investment signal turns positive.

In this example, the manager has no initial exposure to Tencent. However, as the Long signal moves above 0.00, he or she will increase exposure in 700:HK as the signal rises, and decrease exposure as it falls, thereby capturing upside price movements.

It is also possible to employ an Long-Short signal for this type of strategy. See section on “Using an Long-Short signal to trade the short position only".