Hedging with candlesticks

"If you cannot follow a rule, do not begin speculating or investing, as you are sure to lose."

Those were the days when we used place a hedge and forget about it. Hedgers now become more knowledgeable and technically aware thanks to the increased information stream. Hedgers consistently decide about their position and cash management. These decisions effect profitability of an organization. Today with this blog we will learn how candlestick patterns can help in hedging, because many trend reversal candlesticks can assist in timing the placement or lifting the hedge

Let’s first discuss types of hedge:

1. Long Hedge: When underlying position is at risk of rising prices. Take an example of an Equity investor who created a short position in Infosys future for monthly expiry but in very short term he accepts a bullish momentum so he decided to buying a call option or selling puts. If in case price rises in short term then these position can counter balanced by the profits of option positions he make.

2. Short Hedge: When underlying position is at risk of declining prices. For example a copper producer, to manage its risk of falling copper prices he can create a short position by buying a put or by selling a future. If prices of copper decreases in future these positions can be counter balanced by the profits of future and option positions he make.

In many instances, the underlying position cannot be fully hedged or can be misinterpreted or speculative. Thus, the question a hedger must frequently address is what percent of exposure should be hedged. Candlestick technique can help answer this question.

Candlestick technique can be used to get a clue about when to adjust the hedged position of the cash Position. This technique is suitable for those hedgers who wants their position 100% hedged. For instance, let’s say you are long in ITC but the current market trend is against your cash position (means ITC prices are falling). This means as a short hedger your future or option hedge position is profitable and now in instance a strong bullish reversal candle appears and you believe price will rally now and you might want to ease back your hedge position. In various instance, early lifting of hedge position can improve cash flow. Hedging is to tackle risk not to make profits.

Let’s understand this with the help of charts:

Figure 1 Engulfing candle

In Figure-1, here we again taking an example of copper produced who created a short hedge in future or options to minimize risk of falling prices of copper. So in order to hedge his position completely, he can look at candlestick chart of MCX COPPER & find some possible reversal pattern. In the below chart, he spotted a Bullish Engulfing Pattern (a strong bullish reversal candlestick) and decided to ease its current short hedge position as seeing this candlestick pattern, he sees prices will rally in near term. If you look at chart again, On 30^th April, he spotted an bullish engulfing candle, when the prices of copper trades near 16530 after that prices of copper shoots up from that point and rallied till 17747. The position that the hedger ease in short hedge is the direct profit to the copper producer. On 10^th May he spotted an Bearish Engulfing candle (a strong bearish reversal candlestick). So he decide to strengthen his short hedge position, so that he will protected in possible fall in copper prices.

Figure 2 Bullish Harami Candlestick

Example -2: In Figure -2, An equity investor invested in reliance industries share for quite a long time but on 14^th July, after seeing a big red candle he decided to create a long hedge position so that he will be protected from upcoming fall. But later he sees a strong Bullish harmi (Bullish reversal pattern) candlestick pattern on 17^th July. So he decided to ease his long hedge position to take advantage of upcoming up move. On 17^th July price was near 1799 and it rallied till 2196 till 27^th July. Because of easing his long hedge position he generates positive cash flows.

Figure 3 Bearish Harami Pattern

Example-3 , In Figure-3, An HDFC bank Investor, riding a bullish momentum of HDFC bank from several days, but on 19^th Feb he spotted a Bearish harami candlestick ( a bearish reversal candlestick). Then he decided to create a long hedge by selling future of HDFC bank. After that prices of HDFC falls from 1511 to 1341. The hedged position safeguards the profit of the investor.

Conclusion, In this blog we have discussed only three types of reversal candlestick patterns, there are various other reversal patterns which can be more stronger and effective but finding right pattern at right point of time is the key. You will spot various reversal candlestick patterns at various point of time in trading but not all patterns are effective. Spotting right pattern at right time is an art of trading, you need to have that art in order to be successful hedger/trader/investor.

Furthermore, If we combine these candlestick patterns with western technical methods then we can create a powerful synergy too. The more technical signals confirming each other more the probability of accurate trend change.

Thank you

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