The term hedging may seem like jargon to many.
In simple terms, hedging means to cover risks. As humans, we are mostly averse to risks. On a daily basis, we engage in hedging, i.e. planning against risks, in varied ways. The concept also applies when we make investment or financial decisions.
In the below post, we shall delve into detail how hedging can be used to minimise risks in the stock market, especially through future and options.
Understanding Portfolio Hedging
Imagine you own a farm and worry that the crop prices may fall in the near future. In order to safeguard your position or minimise your losses, you enter a contract to sell your crops at a certain price. Now, if the prices fall, you are protected, and if the prices rise, you may miss out on earning a higher profit, but you saved your livelihood.
Similarly, portfolio hedging is protecting your investment from market downturns. There are ways to hedge your portfolio, which include:
- Diversification (spreading investments across asset classes to reduce risks)
- Regular rebalancing (maintaining balance risk exposure by adapting to changes)
- Using derivatives like futures and options.
Let us understand more about hedging through F&Os.
Futures vs. Options
The table below shows the difference between future and options.
|In a future contract, the buyer agrees to buy, or a seller agrees to sell a certain quantity of an asset at a predetermined price at a future date.
|Options give the right, but not the obligation, to sell or buy an asset at a specific price before or on the expiration date. There are two types of options- call and put.
|Both buyer and seller are under an obligation to perform the contract
|No obligation on the buyer or the seller to exercise the option
|No premiums are paid
|Options buyer pays a premium amount to the options seller
|Suitability for Portfolio Hedging
|Yes, investors can lock in future prices for assets, protecting them from potential losses.
|Yes, investors can use options to buy or sell assets at predetermined prices, protecting against potential losses and offering flexibility.
Hedging Strategies with Options
There are four basic options positions that you can exercise to hedge your risk.
- Buying a call option
- Selling a call option
- Buying a put option
- Selling a put option
Put options are a classic hedging instrument. Let us take a scenario to understand hedging strategies by buying a put option.
Imagine you purchase a share of XYZ Ltd. for ₹100, and you expect the prices to fall. To hedge your position, you purchase a put option (right but not the obligation to sell the asset) at a premium of ₹5.
If the stock price drops to ₹80
If the market moves according to your anticipation, you lose ₹20 in the spot market, but you can exercise the put option to hedge your losses. Hence, you make a profit of ₹15 (only you lose the premium amount ₹5), thereby making a net profit of ₹5.
If the stock price climbs to ₹120
If the market performs contrary to your calculations, you earn a profit of ₹20 in the spot market. However, you lose the premium of ₹5 you paid to buy the put option, and your net profit comes to ₹15.
If the stock price stays at ₹100
There is no profit or loss in the spot market. You only lose the premium paid in the derivative market.
Hedging Strategies with Futures
Some common hedging strategies with futures include:
- Hedging by creating a cash-futures arbitrage
- Hedging by locking in a profit position
- Hedging by locking in a loss position
- Protecting risk using beta hedging (for the portfolio of stocks)
Let us take a scenario to understand hedging strategies with futures.
Imagine you purchase 1000 shares of XYZ Ltd. for ₹100, thus making it a total value of ₹1,00,000, and you expect the prices to fall. So, you are currently “long” on the stock and wish to go “short” in the future market.
If the lot size for a future contract is 300, you must buy 3 lots of futures to match your quantity in the spot market. Hence, your contract value will be (300*3*300) ₹2,70,00.
Hedging through futures contracts allows you to cover one position in the spot market with precisely the counter position in the derivatives market.
Implementing hedging strategies with future options is a great way to mitigate risk. However, these tools can be unpredictable. Here are a few things to remember.
- Carefully assess your risks
- Have a good understanding of market trends and underlying asset
- Monitor and adjust your position regularly depending on market conditions
Future and options are popular derivative instruments that market participants opt for to reduce their future risk with their investments. Ensure you keep yourself updated on the latest market trends and opt for a reputed trading platform in India for a balanced and secure investment portfolio.