If you are foreign to the word hedging, it means covering your risks. For example, you buy home insurance to recover the losses if an unexpected event damages your property. Similarly, in investment, investors use various strategies to limit their risk exposure in a trade. Hedging is common and lets investors protect their corpus against unpredicted situations.
Hedging – but why?
As humans, we are naturally risk-averse and engage in hedging activities unknowingly. A real-life example is life insurance that we buy to protect our families against unfortunate events. Similarly, an investor might want to protect his investment against market volatility resulting from an impending war or an economic breakdown.
In the absence of a hedging strategy, you either have to withdraw your investment and book profit or let your investment plummet when the market goes down. Either of these situations is not suitable as a long-term investment strategy. To avoid these instances, you can use hedging to safeguard your money.
Derivatives are widely used for hedging strategies in the world of investing. It means taking contrasting positions to protect your portfolio when the market plummets. It can be done two ways – hedging with options and hedging strategies using futures. We will discuss both, so read on.
What is a risk?
Since we try to hedge against risk, it is crucial to understand what risk is and the type of risk you can hedge. Typically, risks are of two kinds – Systematic and Unsystematic risks. When you buy a stock in the share market, you automatically get exposed to these risks.
An example of unsystematic risk is when the stock price declines for reasons specific to the company. Since these reasons don’t affect the competitors, these are unsystematic risks. A company’s share price can decrease because of:
- Declining revenue
- Declining profit margins
- Higher financing expenses
- High leverage
- Misconduct by the management
You can mitigate unsystematic risks through diversification.
Systematic risks affect all the stocks. These are usually macroeconomic traits that affect the whole market.
- Declining GDP
- Rising fiscal deficit
- Geopolitical crisis
- Increase in interest rates
Systematic risks are inherent to the system and can’t be avoided through diversification. But we can use hedging techniques against systematic risks. So when we discuss hedging with options or futures, we talk about systematic risks.
Hedging in the futures market
Futures is fungible contracts that allow the contract owner to buy/sell an underlying asset at a future date for a pre-determined price. Futures have a limited lifespan, and it is obligatory, unlike options. When investors use futures contracts for hedging, their goal is to reduce the likelihood of loss due to an unfavourable market value of the underlying asset. When the underlying asset’s value is far too volatile, the investor is more likely to purchase futures contracts for hedging. Investors will take a long position with futures contracts if they know they will buy an underlying asset, in the long run, to lock in a favourable price.
Let’s understand with an example of a single stock position.
You buy 300 stocks of company X at Rs 2350. It works out as an investment of Rs 7,05,000. Obviously, you are long with the stock. Now you realise that they are about to release quarterly results and expect the share price to fall. You avoid incurring losses by entering into a hedge with a short position in the futures market.
The short futures trade may look like
Short futures @ Rs 2355
Lot size 250 stocks
Contract value Rs 5,88,750
The overall position becomes market neutral.
Single stock hedging is very straightforward. You cover one position with a precisely opposite position. It provides immunity to your investment and makes it indifferent to what happens in the market.
Hedging strategies using futures can have multiple legs involved. But the above instance is a good starting point to understanding the overall game.
Hedging with options
Options is standardised financial contracts that allow the options owner rights but no obligation to trade an underlying asset. Like futures, traders also use options for hedging. Let’s consider a similar situation.
When market uncertainties rise, traders try to avoid losses as the price plummets. Similarly, they also don’t want to lose the profit opportunity.
Assuming that you buy stocks of company X at Rs 100 apiece, three possible scenarios can happen. Supposedly you buy a put option at a premium of Rs 5, anticipating the stock price will fall and magnify your profit opportunity.
The stock price moves to Rs 110
If the market moves against your anticipation, you can let the contract expire and earn a a profit of Rs 10 on each share. In this case, you pay Rs 5 in premium, and you make a profit of Rs 5.
The price declines to Rs 80
We lose Rs 20 in the cash market, but at the same time, we make a profit of Rs 15 in the derivative market. Your net loss, in this case, is the amount paid in premium.
The price remains unchanged
If the price doesn’t move, you will not exercise your rights. Your loss in the whole scenario is Rs 5 paid in premium.
It is a scenario involving single stock option hedging strategies, but a portfolio often has multiple stocks. A workable plan is to calculate the portfolio beta and take a short position in the NIFTY. In simple terms, beta denotes the sensitivity of a stock concerning the changes in the market. The portfolio beta is the weighted beta of each stock.
Hedging futures with options
Investors use options for hedging futures with options. It depends on the market situation, risk abilities, and investment volume.
Your choice of options will depend on your position in the future. Traders can use a long call or a short put to hedge short futures. Similarly, a long put or sell/short call for covering the risks from long/buy futures.
Futures and options are excellent financial tools to cover risks and seal the price of an underlying asset during market uncertainties. However, you must understand their nature and risks before including futures and options in your trading strategy.
Disclaimer: Angel One Limited does not endorse investment and trade in cryptocurrencies. This article is only for education and information purposes. Discuss with your investment advisor before making such risky calls.