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Algorithmic hedging is the practice of executing risk-reducing trades via an algorithm, typically used by a market-maker.
These algorithms seek to strike a balance between retaining as much bid/offer spread as possible and limiting the amount of residual risk on the market-maker’s books. Perfect hedges will wipe out the market-maker’s profit, but loose hedges may prove ineffective when markets are volatile.
Within parameters set by the market-maker, hedging algorithms operate on similar logic to pricing algorithms – analysing a mix of price, liquidity and inventory inputs to judge where to execute the optimal hedge. Again, as with pricing algorithms, their use is most common in active markets, and they may act as a support tool to human traders, who then accept, amend or reject the algorithm’s suggestions.
See also algorithmic pricing.