risk
Hedge Away Unpaid Risk
The rule
Keep only the one risk you truly understand. Cancel every other risk riding along with it, like removing extra weight from a boat.
Where it flips
Push it too far and the cost and fuss of hedging eats your return, just to cancel a risk that barely mattered. Or you hedge so tightly that you also kill the very edge you wanted to keep. The fix: hedge only the risks you cannot judge, and price the hedge. If it costs more than the risk it removes, just carry the risk.
Thorp liked to separate the bet he understood from the market noise around it. Say your real insight is 'this one thing is priced wrong'. Then the direction of the whole market, the rupee, or the sector is extra risk you carry for free. Nobody pays you for it. The discipline is to cancel out those side-risks with an opposite position. Then your result rests on your real insight, not on a coin-toss you were never paid to take.
A worked example
Rohan is sure a merger between two firms will go through. So he buys the target at ₹480, against a ₹500 offer. To avoid also betting on the whole market, he shorts an equal amount of the buyer. Now he earns the ₹20 gap whether the Nifty rises or falls. [illustrative]
How to spot it
- ·One clear insight buried under whole-market risk
- ·Asking 'am I being paid to take this risk?'
- ·An opposite position that leaves only the real bet
Edward O. Thorp · A Man for All Markets