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:

• 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 primary hedge directions can be summarized as follows:

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:

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:

Use the slider above to view how to allocate assets as the signal changes.

In other words, as the signal becomes 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 a 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, one trades only the negative signal values (0.00 to -1.00) while ignoring positive signals.

This strategy is best employed by traders who already have 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, decreasing downside risk:

Scenario:

Use the slider above to view how to allocate assets as the signal changes.

In the above scenario, when 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 a Long-Short signal to trade the Long position only

Goal: Increase the upside capture

Trading only the long position can be interpreted as a buy low/sell high approach. The goal is to improve 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 strategy is the least risky way to trade Long-Short signals and is best suited for less-experienced traders or experienced traders looking to time market entry.

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

Scenario:

Use the slider above to view how to allocate assets as the signal changes.

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 bullish.

Short signal trading

Less common than Long-Short signals, Short-only trading signals focus on reducing drawdown on positions that 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 maximum bearish. There are no positive signal values for Short signals.

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

Scenario:

Use the slider above to view how to allocate assets as the signal changes.

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 a 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 maximum bullish.

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

Scenario:

In this example, the manager has no initial exposure to Tencent. However, as the Long signal moves above 0.00, they 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 a Long-Short signal for this type of strategy. See section on “Using a Long-Short signal to trade the short position only."