A hedge happens when you are Long and Short positions within financial markets, thereby canceling any market risk. In this case, we are interested in Light Crude oil prices, and looking to use ETFs (that tracks and correlates the Oil prices) to find a good hedge and profit from it.

The following Stock is a product of ProShares Trust ProShares Ultra/Short DJ-UBS Crude Oil, a little description from Google’s finance site:

Description
ProShares UltraShort DJ-UBS Crude Oil (the Fund), formerly known as ProShares UltraShort DJ-AIG Crude Oil, seeks daily investment results that correspond to twice (200%) the inverse (opposite) of the daily performance of The Dow Jones—UBS Crude Oil Sub-Index (the Index). The Index, a sub-index of DJ—UBS Commodity Index, is intended to reflect the crude oil segment of the commodities market. The Index consists of futures contracts on crude oil only. The Index is valued using the settlement prices for the underlying futures contracts.

The hedge occurs when we are Long a stock ticker UCO for long direction for Crude Oil prices and Long a stock SCO for invest short position for Crude Oil prices

Before you begin this please look at the simplest dumbest way to use ETFs to trade, in case you haven’t know what UCO and SCO these 2 symbols means.

UCO = Prices goes up when Oil prices goes up
SCO = Prices goes up when Oil prices goes down

This strategy involves averaging up and/or down, and clear with the use of leverage/inverse leverage of ETFs. Added to the advantage is both ETF are 200% leverage, meaning if you had $1000 in UCO, a 1% increase in Light Crude prices equates roughly 2% for stock price of UCO. The same happens for SCO, or if you decided to short UCO.

Assuming Oil prices moves fluctuates to high and lows in a 5-10 day period, in these examples we do not care what are the oil prices, but instead go by percentage points.

Let’s give 2 hedging scenarios:

1) Oil moves lowest point.

UCO = $9
SCO = $16.66

Long UCO
100 x $9.00 = $900

Oil then moves up 5%

This causes UCO to go up 5% (200% = 10%), now @ $9.90

This causes SCO, to drop 5% (200% = 10%), now @ $15.

Long SCO
100 x $15 = $1500

Portfolio:
$0.90 x 100 = $90 Profit from UCO
$0.00 x 100 = $0 Neutral from SCO

Now you have a “perfect” hedge, because any movement in Oil prices will allow you to gain in both stock prices, or to cancel out any losses with profits from the other side. Hows the downside ? Brokerage fees. Now let’s look at example 2 with the same scenario.

1) Oil continue to rise. (Add positions to SCO)

UCO = $9.90
SCO = $15.00

Oil then moves up 3%

UCO = $9.90 + 6% = $10.50
SCO = $15.00 – 6% = $14.10

Long SCO
100 x $14.10 = $1410

Portfolio:
$10.50 – $9 x 100 = $150 Profit from UCO
$14.10 – ($15.00 + 14.10)/2 x 200 = $90 Loss from SCO

As you can see, the current standing is with profits from 100 UCO, you can safely long SCO because the prices of oil might have reach top. Let the Oil run for a few more percentage points, and demand will drop, thereby causing prices to drop.

Now onto Scenario 2:

2) Oil drops abruptly 4%. ( Do nothing)
Oil then drops another 7%, due to some rare events. (Long 100 UCO)

Let’s calculate the UCO SCO prices and portfolios:

UCO = $10.50 – 8% = $9.66
SCO = $14.10 + 8% = $15.22

Portfolio:
$9.66 – $9 x 100 = $66 Profit from UCO
$15.22 – $14.55 x 200 = $134 Profit from SCO

Now we see a total of 200, exactly before trading and brokerage fees. We need to consider 5 trade fees, 3 buy and 2 sell trades to clear off all positions.

Now you may wonder what if I am very smart and able to time the market to just buy and sell a single security UCO Long Oil. The difference is with just buy/sell, you generate more trades, while increase you risk as your VAR is @ 100%. Any drop in price means you lose the value.

If I sold UCO with a $150 profit, and oil prices continue to rise, then I’ll miss the boat. If it drops count me lucky. But, If I bought SCO instead, and oil prices continue to rise, then I am hedged, lowering my risk while lowering returns, though.

Let’s calculate the UCO SCO prices and portfolios:

Oil then drops another 7%, due to some rare events. (Long 100 UCO)

UCO = $9.66 – 14% = $8.30
SCO = $15.22 + 14% = $17.3

Portfolio:
$8.3 – $9 x 100 = $70 Loss from UCO
$17.3 – $14.55 x 200 = $550 Profit from SCO

Long UCO
100 x $8.3 = $830

Portfolio:
$8.3 – ($8.3 + $9)/2 x 200 = $70
$8.3 – $8.65 x 200 = $70 Loss from UCO
$17.3 – $14.55 x 200 = $550 Profit from SCO

Your positions won’t be affected by this long because it will depend how the prices move next. What you see now is a hedged positions with 200 shares long each, with a difference of $480, before trades.

Total trades = 4 buy, 2 sell.

Now taking that away will be $480 – 6 trades x $15 = $390. the $15 is my brokerage trade fees.

Another thing is with 200 shares on both long and short, you are neutrally having 0% at risk, though this is not risk free. The market risks causing oil prices to move will be “neutralize” hopefully, because of the dollar cost averaging as well as hedging involved.

Disclaimer: This is a simple yet a difficult strategy for hedging and neutralizing any market risks. To understand this, you would be required be both an active trader, a sound fundamentalist/economist, and the ability to recognize what are good prices to enter the ETFs trade and such. That, would be harder to blog and would not be covered here.

ps: I am *sometimes* using this strategy myself, so this is very revealing. Though market conditions may change, this is subjected to experience and risk per investor.