When Adding A Hedge Increases Risk

• Posted by DynamicHedge
• on April 11th, 2011

On Friday many refiner stocks had been sold off to the tune of ~5%.  With the seasonality of driving season and the tensions in the Mideast, it makes sense to have some exposure to refiners.  So I entered the spread long WNR short HOC.  My ratio is 6 * WNR – 1 * HOC.  My signal actually flagged on the 3 * WNR – HOC ratio, but I wanted a little more exposure to WNR due to the emotional nature of the selloff.

Let’s compare the historical risk that you would have been exposed to if you had traded the 6 * WNR – HOC relationship in the past 6 months versus trading just WNR using the simple parameters of 6-months total range and average daily range to measure risk.

The spread has $50 range and a $3.37 ATR while the individual stock has a $14 range and a $0.93 ATR.  Adding 100 shares of HOC short actually triples your total risk in the trade instead of reducing it.  From a practical perspective you will make money on the HOC short if refiners sell off further, but is it worth the additional volatility and risk?  If the reason for entering the spread was to scalp volatility then this is a great pair.  If you have a view that refiners will move higher in the coming weeks you should stick to the single stock.  Needless to say, I covered the HOC short.  No need to be dogmatic.

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