Asymmetric Hedging

Asymmetric Hedging is structuring an investment hedge to offset risk in other holdings with an asymmetric payoff such that the potential profit form the hedge is materially greater than the amount of risk taken to achieve it.

Asymmetric Hedging

Asymmetric Hedging is when we lose a predefined amount if the protective hedge for risk management isn’t needed because the price trend continues, but the position explodes with profit when the underlying trends.

An example of asymmetric hedging: If we risk $100, we’d prefer to earn $500 for it to offset what may be $500 or more decline in value of other holdings as opposed to risking $500 to offset $500 symmetrically.

Asymmetric is an imbalance of profit and loss or lack of symmetry. In investment management, we refer to an asymmetric profit over loss, or asymmetric payoff with a high gain over loss or higher potential for upside than the risk of downside.

Hedging is a risk management strategy applied to limit or offset the possibility of loss. The effect of hedging is transferring a possibility of loss, or risk, or to limit the loss by a hedging position that offsets the loss in another investment position.

Asymmetric hedging, then, is when we skew the payoff asymmetrically, so that the potential payoff, or the actual payoff after it is realized, has a greater profit than loss. For example, if the downside risk were 1%, but the realized gain was 2%, the asymmetric payoff was 2:1. Applied to dollars, it could be risking $100,000 to earn $200,000. With asymmetric hedging it could be we risked $100,000 to hedge off $200,000 of risk. We can target an asymmetric hedge by structuring the trade so the payoff is materially greater than the potentila for loss using positions such as long volatility or leveraged ETFs with a predefined exit to limit the loss.

Another simple example of an asymmetric hedge is buying a protective put option*, a strategy that consists of buying puts as a means to profit if the stock price moves lower. A protective put consists of adding a long put position to a long stock position to hedge it against a price downtrend. As seen in the diagram, the maximum loss is limited. The worst that can happen is for the stock to drop below the strike price. In theory, the potential gains of this strategy are unlimited. Of course, when we own the stock, the best that can happen is for the stock price to rise to infinity and we simply lose the money we paid for the put option. Please note, however, the timing of these positions and how they are constructed are far more complex than this idealized example. When we buy or sell options, we analyze them for the best relative value between implied and historical volatility.

asymmetric hedge protective put

Asymmetric hedging is an effort to skew the payoff to achieve an asymmetric payoff with the hedge, so we are using capital efficiently. If we are going to risk capital to hedge off the possibility of losing money in our holdings, we prefer an asymmetric payoff potentila over symmetry.

Asymmetric hedging: If we risk $100, we’d prefer to earn $500 for it to offset what may be $500 or more decline in value of other holdings as opposed to risking $500 to offset $500 symmetrically.

On the other hand, a symmetric hedge is when the payoff is the same as the potentila for loss. An example is selling short a stock index ETF to hedge off market risk in a portfolio. However, if unmanaged, the payoff long term of selling short results in an unlimited loss if the stock index trends up long term, but the potential profit is limited to the amount it can decline in value (100%). As such, asymmetric hedging is a tactical portfolio management endeavor require our skilled tactical trading and advanced position structuring.

Keywords: asymmetric hedging, asymmetric hedge, asymmetric risk reward, asymmetic risk return, asymmetric payoff.

*Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options.