To answer this question, I looked up some of the most common approaches to hedge.
If you’ve worked in a professional brokerage, you can probably attest that it’s not that hard to stop a client when their money is going bad. In the US, brokers do get paid based on the spread on the last trade and then send their profits to clients. If the spread is large, they would be paid less. This is a huge problem in the UK, where clients have less ability to get their money back if they lose money. In order to prevent the spread from getting too large and forcing clients to get out of a position, brokers have to either hedge the last trade by using stop losses or buy the position when the spread has reached a level where it is no longer worth doing business with it.
There are three main approaches to hedge in the professional trading world. The first two are known as ‘diving’ and ‘wedge’ hedging. I’ll call them ‘diversifying’ and ‘diving’, as these are the two ways traders trade the market that the professionals use. The third alternative is called a ‘cross betting strategy’ and I’ll call this that just too – because it involves multiple exchanges (and an additional risk in the case of a bad trade). I’ll call it the ‘stratified strategy’ or ‘STR.’ In practice we have a number of traders employing some combination of the strategies discussed above, in order to hedge their profits from various markets, especially in the futures markets and in gold.
If you have to ‘divert’ your losses in a specific market, there are four different ways an individual can hedge:
1. Diving using a cross betting strategy on a given exchange, which involves using that exchange’s own market price to calculate the trader’s losses. For every trade, the broker will ask for the futures bid and ask prices for that same futures contract to use as the basis for the trades when calculating the trader’s losses. This can be very risky as the futures market is very volatile, and traders may see huge gains or losses when they buy and sell futures contracts.
2. Diving the trade as explained in step 1 with a cross betting strategy (the most commonly used). There is a huge gap between the futures trading venue and the market, which can make things very complicated. Most exchanges do not have a single, ‘official’ price index to help hedge the trades. This is where professional traders come in to fill in
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