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Things to do with futures: hedging
You must have heard this statement often that investments are subject to market risk. As a beginner, you might be cautious about the losses associated with investments, but this is true that with the increase in your capacity for risk, the chances of opportunities and strategies also increase. And to help in doing so, hedging plays an important role. In this chapter, let’s understand what is hedging and what are its advantages.
The standard convention, which is followed in the stock market, is known as hedging. In simpler words, investors employ various types of hedges to protect themselves from monetary losses which they might have to incur due to fluctuation in the market.
Hedging is a convenient practice which you must learn before you begin investing. Let’s begin by understanding the meaning of hedging, which is protection. Hedging means safeguarding your losses from increasing and also protecting your profit from decreasing. Hedging acts as a fundamental way by which you can save your investment portfolio. To counterbalance the potential losses in an investment, hedging works as a risk management strategy. Futures and options like derivatives are involved in hedging.
While managing risks, we typically use futures generally. You can also purchase futures as a proxy for cash market positions. However, that is not the main reason for using futures. Futures work best when they are used for hedging.
Now, let us understand how we can hedge stocks with futures and what are the hedging strategies which are used with futures.
Hedging with the creation of a cash-futures arbitrage
The most common and passive form of hedging is by creating a cash-futures arbitrage. In this case, firstly you buy a stock in the cash market and then sell equivalent futures. You must remember that the futures are sold in minimum lot sizes. You will have to match the cash market position with a lot of equivalents. Let us understand this with an example:
On the trade date
Amount Details On F&O Expiry day
Amount Details Buy 3000 shares SBI Rs.259
Sell 3000 shares SBI Rs.285
Sell 1 lot of SBI Futures Rs.261
Buy 1 lot SBI Futures Rs.285
Arbitrage Spread Rs.2
Profit on SBI Cash Rs.26
Arbitrage Yield (%) 0.77% per month
Loss on SBI Futures Rs.24
Annualized Yield (%)9.64%
Net Profit on Arbitrage Rs.2
In the above example, since the cash and the price of futures will be closing at the same level on the F&O expiry date, hedging becomes possible.
Thus the Rs. 2 arbitrage spread which you have locked now is realized. This converts to an annualised yield of 9.64% for the arbitrageur, but in most of the cases many arbitrageurs do not hold on until the date of expiry. In case they reverse the trade if they get a sharp spread compression and book the profits.
Hedging by locking in a profit position
When you expect the market to become volatile, hedging by locking in a profit position is a good method. Let us understand this with an example- Rajesh purchased 1000 shares of Whirlpool a year back and Rs. 500. After the period of one year, the company launches as a new product, and the stock appreciates to Rs.950. Now the return of Rs. 450 is a good return as per the time. Now when Rajesh is a long term investor in Whirlpool, he would want to see his cash position. Now he can sell the equivalent 2 lots of Whirlpool futures for about Rs.960 (futures are generally quoted at a premium). The difference in price which is locked in is his assured profit. If he chooses to do nothing during the month, his profit is assured. The added advantage which he enjoys is that he can earn the premium on short roll and roll over the short futures each month.
Hedging is done by locking in a loss on the position.
In this method, the goal is to protect an investor’s losses beyond a point. Therefore, it is used to protect the risk. Let us assume that Rajesh bought Reliance stock at Rs.370. The stocks’ value decreased and they suddenly fell to Rs.355 due to a failed product launch. What would Rajesh do now?
Sell 1 lot Futures Rs.358
Buy Price Rs.370
Loss locked in Rs.12/share
Current Market Price Rs.355
Roll prem. for 6 month Rs.9/share
Notional Loss Rs.22,500/-
Making this decision will help him especially when he is expecting some structural damage to the stock in the short term, but he is also confident about it in the long term. It makes sense in the immediate term for him to lock in his losses as in the above case. As he will roll over each month and earn a premium, he will be able to reduce his loss on the position eventually. He can cap his loss and understand his position subsequently.
Protecting risk using beta hedging.
In the above instances, we have looked at cases which involved individual stock holdings. However, if a trader is holding on to a portfolio of stocks and he is worried about a global risk which can possibly take the entire market down then he will have to sell the Nifty futures. Now the question arises that what number of Nifty futures should a trader sell in order to hedge the risk completely. Beta hedging is used in such scenarios.
Amount Number of stocks in Mr. Sinha’s equity portfolio 12 stocks
Current Value of Equity Portfolio of Mr Sinha Rs.35,60,000 (A)
Weighted Average Beta of the Portfolio 1.18 (B)
Nifty Futures to be sold for perfect hedge (AXB) Rs.42,00,800 (X)
Market Lot size of Nifty 75 units
Current price of Nifty 10,392
Market value of 1 lot of Nifty Rs.7,79,400 (Y)
Number of Nifty lots to be sold for Beta hedge (X/Y)5.39 lots
Obviously you cannot sell 5.39 lots of Nifty so you will have to sell either 5 lots or 6 lots of Nifty depending on how aggressively you want to beta hedge. You may not get the perfect hedge, but you are much closer to comfort!
Now that you understand Hedging in futures, it’s only logical that we move on to the next big topic - Things to do with futures: reading and using Open Interest data. To discover the answer, head to the next chapter.
A Quick Recap
- Hedging is a strategy that tries to limit risks in financial assets.
- Popular hedging techniques involve taking offsetting positions in derivatives that correspond to an existing position.
- Other types of hedges can be constructed via other means like diversification. An example could be investing in both cyclical and counter-cyclical stocks.