What is a Rio Hedge?

The Rio hedge is a tongue-in-cheek term used by traders who face liquidity issues or capital restraints, but still put on a risky trade. If the trade goes badly, the trader will execute the Rio hedge, that is, a plane ticket to a tropical location such as Rio de Janiero, to escape financial responsibilities.

Essentially, the Rio hedge is a form of gallows humor.

Key Takeaways

  • A Rio hedge is when a trader takes a risky bet and they hedge by buying a plane ticket to a tropical island, just in case it doesn't pay off.
  • In general, traders should never risk a trade that can result in ruin.

How a Rio Hedge Works

The Rio hedge is often associated with trades with more risk relative to the potential return, such as large naked short positions.

Generally, most professional traders infrequently trade positions that might result in the need for a Rio hedge, instead choosing to more carefully manage risk with a series of less-risky, disciplined trades over time.

The Rio hedge, while mildly funny, highlights problems many traders face, especially beginners who are new to trading. This includes potential margin calls and personal credit risks should things start to go quite badly. While trading can be lucrative, it’s not uncommon for individual traders with little experience to see large account drawdowns.

Trading is not for everyone. For those who do intend to trade individual stocks, commodities or futures, paper trades and starting with a small amount of capital can help avoid the Rio hedge, as will a lot of practice and training.

One place to learn trading is the CMT Association, which issues the Chartered Market Technician examination. This test requires hundreds of hours of study, and thoroughly covers topics such as risk management, behavioral finance, and trading-systems testing.

Aspiring traders can also consider the pros and cons of various online trading academies.

Have a Trading Strategy to Avoid the Rio Hedge

A proper trading strategy involves first defining the types of securities to be traded, the associated patterns, the typical time frame for each trade, position limits and strict rules governing entry and exit points. Discipline is key.

Note that many experienced traders expect to be “right” roughly half of the time with their trades. The way many of them turn a profit over time is by dealing only with liquid positions, carefully controlling costs, and by evaluating technical risk-reward in a way that “lets the winners ride.”

One way to let winners ride, for example, is by utilizing areas of technical resistance and support. When putting on a long position, an experienced trader typically places a stop order slightly below the area of support, then looks for a trade with significant room to run before the next area of technical resistance.

For some traders, a long trade may have a technical risk/reward ratio of roughly 3-to-1. What this means is there’s three times as much room for the long position to move upward to resistance as there is for the stock to move down to the stop.