Advent of Alpha Day 7: Hedging

You back a selection at 2.0, your bet is matched and now it’s sliding in. 1.95… 1.9… 1.8… 1.7… should you lay it off?

There’s a lot of discussion about this in some circles. One group is “never green” - if you had edge at 2.0, ask what’s changed now? Giving money back to the market means you reduce your profits.

I’ll say you should often consider hedging. Often enough in fact that on many strategies I’ll have a ’limit on close’ order or ‘market on close’ order to close my positions. Why?

1. Variance. I want to reduce the roller-coaster ride on my bank. I’m happy to pay back something for this. A bunch of losses in a row still feels horrid, even if I know I had edge.
2. Sometimes it’s hard to quantify my edge, and this means I’m reduced risk of overbetting - I don’t have to hedge my entire position, I can just reduce it and make sure I’m inside Kelly maximums.
3. On a personal level, nothing makes me warmer inside than an all-green book, even if the lowest position is flat to zero, and I’m still hoping for one or two selections to win out.

The couple of basic hedging strategies that can even out variance, reduce exposure to overbetting and make life a little more pleasant (or at least, in my case, less stressful) are:

1. Take the other side of the market the moment it in favour to the same stake size. This is the core of market-making.
2. Take out a market-on-close bet to counter your position when the market goes in play, if you’re betting pre-off. This also works as a stop-loss position if your position starts to move against you.
3. Persist into market on a counter-position to your original position, but be aware this might just mean you’re compounding losses and not compounding wins if your selections regularly move against you when going in-play (for example, laying the draw pre-off in soccer is impossible to counter into a hedge if the game stays 0-0, you’ll need stop losses to get out).
4. Slightly more finicky is to take a limit-on-close order, and if your bet doesn’t get matched in the auction, re-enter the market to stop loss or hope to get matched in-play as above.

If you know how to calculate true prices and edges at any given point in time, just keep plugging away at Kelly with your current positions factored in. This is the one true way to profit maximisation, but it comes with the caveat you need to be confident you know what the true prices and edges are right now, consistently. Do you? How do you know that? Do you know how to calibrate? If not, that’ll come up soon…