Hedging Choices (Experienced Traders)

To the experienced traders, you know who you are... Do you think the correlation or co-variance matrix is better to assist with hedging? Also let's say for some odd reason I wanted to trade front spread and back spread and they have different betas.. How would you find hedge ratio? I'm gonna assume you will have to factor in co-variance to account for volatility? Let's say I hedge, do you hedge to keep it risk neutral or at the same, do you try to find possible alpha opportunities to offset a bad trade? Example, turning a spread into a fly. Like let's say I'm trying to hedge a Cal20 strip and I use the front '19 so I build up spread risk along the curve while I'm delta neutral, how would you hedge or what opportunities can I flip this around to possibly turn into a relative value opportunity trades on the forward curve?

 
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can be a mistake to blindly use correlation/covarance matrix (depending on the fundamental / mathematical relationship between the securities). (read the wiki)

First you need to know if your securities have a linear relationship over time. If yes, then this approach can work...but you need to inspect how they behave to determine if PCA is the right approach (i've seen things blow up when a relationship was assumed to be linear when it really wasn't...many things are linear in a very small slice of time and price...but over a larger sample they are not).

If the relationship is not linear, then using a linear approach will still give you an output, but it won't be a mean reverting process, which is what you are looking for...in which case you'll just end up with a random outright position and risk that is not what you are expecting. This is something that neural networks are good for (i suggest you could use auto-keras to find the right neural network approach).

However, before going the ai route (which i suggest you learn if you are not there yet) i always start charting the individual securities in one chart over both a longer time frame, and then i zoom in to shorter time frames, and ask myself "does this make sense?" You are looking for a way to understand the relationship...and then you can use the math to zoom in.

Co-variance itself is an intermediate step in calculating PCA...you normalize the co-variance into correlation co-efficients (correlation co-efficients are the slope of the linear relationship)

in the line formula y=m*x+b
y is the price of security A (the dependent variable...the value we are searching for, given x) x is the price of security B (the independent variable...the known thing) "m" is the correlation co-efficient...also called the slope...which is also your hedge ratio (if the relationship is indeed linear).

in the interest rate world, things are linear in a very small slice of time/price...but over a larger sample size, things are not linear. (imagine the price to yield chart...its asymptotic to both axis...so not linear....but in practical terms its usually linear at any one point in time )

just google it...you're welcome
 

I know within rates, the three biggest variances in PCA is level, slope and curvature, respectively... in commodities, what would those be? I haven't heard much about PCA being used for neutralizing certain risk factors in commodities. Personally I've never calculated PCA... trying to find cov - var matrix and using linear algebra to find the eigenvalues and eigenvector... is there any easier way to learn?

 

each market trades a little different, and i'm not familiar enough with the dynamics of how your market trades (i'm assuming nat gas, but could apply to other things).

for example, if we were talking about eurodollar futures....then i'd know that the thing being measured by the market is the implied fed path...and changes to contract prices are changes to the expected fed path, plus a credit spread between fed funds and libor.

In your market, what external things can you isolate...what is the market measuring? Nag gas is also implicitly measuring weather expectations (demand), extraction, transportation and refining issues (supply)...etc. Now, if none of those things have changed, then sure, spreads can be turned into flies...otherwise you are implicitly taking a position on that externality.

just google it...you're welcome
 

regarding hedge ratios...each market is different...but generally speaking, i would start with visually inspecting the price history of the various contracts that you are considering spreading...and with your eye you can usually determine "are these linearly correlated?"

Excel has some functions to determine the stength of the linear relationship (Slope, Correll, Linest) that are useful.

just google it...you're welcome
 

faceslappingcompilation Hey question, so let's say we have a feb-dec strip and the product is illiquid and the spread is very wide so we don't know how to value these this.. so I bootstrap the outrights down the curve to find the value but I have to make a market for a GZ9 strip vs cal 20... how would you make a market on this?

I mean I can use the midpoint of the front strip but it may not be perfect as it should be off value a couple ticks but let's say i want to be spot on, arb free

Also lets I am able to make a market on this, what would you do with that residual lot? Just gtfo? The reason why i ask is because I'm trying to be active on RFQs and it was one the instrument someone was seeking on CME direct

 

when you have illiquid securities....you need something liquid as a reference, and then you need a valuation model...which you use to determine what the right price should be for the illiquid stuff. The valuation model is generally the hard part...and is different for every market. (this is my way of saying, i don't know enough about the markets you are trading to be able to be much help here)

just google it...you're welcome
 

Yeah.... The problem is, even the outrights aren't liquid as you go further back of the curve but the Qs and seasonal strips do get traded more but the problem is, as the strips get traded, the spreads may lag and obviously you can potentially find an arb opportunity if you guess it right and try to find which has a higher beta and how to split it evenly but I'm trying to remove from making manual values

I can use the front outright and the front spread and bootstrap it down the curve to get the second leg bid offer but even then it's still hard because the spread can be like 60 ticks wide.

FYI - this is the European natgas, which is mostly commercials trading this shit so I better be right on my values lol because it can literally move 2 cents in a second

 

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