In the literal sense, a hedge is a protective fence. However, in the financial parlance, hedging refers to a risk management strategy that aims to achieve a net-zero effect for a trader. A hedger takes a counterbalancing position using Futures & Options (F&O) to an already established trade position.
How should you hedge using derivatives?
Hedging using derivatives may look difficult initially, but in reality it is not as complex as it may sound. Hedging can safeguard you from market volatility and directional risk, you otherwise run in unidirectional trades.
For instance, long trades without a protective shield of shorts can land you in trouble if the market crashes contrary to your expectation and vice versa.
Essentials of hedging with F&O
|View on the market direction||Established position (1st leg of the trade)||Counterbalancing action(2nd leg of the trade)|
|Bullish-to-Neutral||Long (Initially, investor is a buyer)||Short-sell future/write a call/buy a put|
|Neutral-to-Bearish||Short (Initially, investor is a seller)||Buy future/buy a call /write a put|
(For illustration purposes only and shouldn’t be construed as investment advice/recommendation under any circumstances)
Hedging using index futures
If you own a portfolio of bluechips and know their Beta values, you can even hedge your investments with index futures. Beta shows the return sensitivity of a portfolio to that of an underlying index. A portfolio of Rs 12 lakh with a weighted average Beta of 1.1 should be hedged for a value of Rs 13.20 lakh (Rs 12 lakh X 1.1).
Hedging a portfolio of investments by selling index futures
|Stock||Value of investment (Rs)||Portfolio Weightage||Beta Value||Weighted average Beta|
|Titan Company Ltd.||225000||19%||1.02||0.19|
|Bajaj Finance Ltd.||2,00,000||17%||1.44||0.24|
|Reliance Industries Ltd.||2,00,000||17%||1.06||0.18|
|Tata Motors Ltd.||1,50000||13%||1.47||0.18|
|Sun Pharmaceutical Industries Ltd.||75,000||6%||0.62||0.04|
|HCL Technologies Ltd.||75,000||6%||0.92||0.06|
|Adani Enterprises Ltd.||75,000||6%||1.31||0.08|
|Larsen & Toubro Ltd.||75,000||6%||1.07||0.07|
(The portfolio above is for illustration purposes only and shouldn’t be construed as investment advice/recommendation under any circumstances)
Suppose Nifty 50 has been trading at 18,600 in Futures and the lot size is 50, which translates to a contract value of Rs 9.3 lakh (18,600 X 50). You will have to sell 1.4 lots of Nifty 50 to completely hedge your portfolio. (Rs 13.20 lakh/Rs9.3 lakh)
Since fractional trades aren’t practically possible, you can either sell one lot or go for two lots. You might end up either over-hedging or under-hedging your portfolio.
Now let’s see a trade off. Suppose Nifty 50 slides 5% (930 points), your short position in Nifty Futures will make a profit of Rs 46,500 or Rs 93,000 depending on how many lots you sold, one or two.
What will happen to your portfolio? Since the weighted average portfolio Beta has been 1.1; your portfolio may drop 5.5% (Or by Rs 66,000).
Instead of shorting Nifty Futures you could hedge with options—buy a put option or write a call depending on market conditions, time to expiry and your directional expectation.
Learn hedging with option examples:
You can hedge your individual stock exposures by taking a negating position in F&O.
Let’s assume you bought 1,425 shares of Tata Motors in the spot market at Rs 440/share. Although your view is bullish (that’s why you bought the stock), you are slightly concerned with market volatility and decided to hedge your position. Here you have two options. Either you can write a call or buy a put depending on how confident you are on your assumption of the market direction.
If you write a call option with a strike price of 440 it can fetch you a premium of Rs 19,950 (1,425 shares X premium of Rs 14).
If the stock price rises above Rs 454 your potential loss on the option leg of the trade would be unlimited, at least in theory. Your spot position will continue help you benefit from the upside though.
This strategy is popularly known as the Covered Call strategy.
Mind you, every option has a time value; a rally in a stock towards the fag end of an expiry may not affect your option position as much. In this case, you are hoping to enjoy the time-decay on the call option premium.
How to hedge a short position in F&O using options?
Suppose you short-sold Reliance Futures for the nearest month expiry at Rs 2,740.
You don’t expect Reliance to rise sharply from here onwards. But just to minimise your risk exposure, you might want to write a put option of the nearest month expiry with a strike price of Rs 2,740 at Rs 60.75. You will lock the premium of Rs 15,187 (250 shares X Rs 60.75).
Your put option will start making you losses only if the stock price falls below Rs 2,679. Don’t worry! Your short position in futures will cover up your losses on the option trade thereby offering you a hedge. This strategy is called Covered Put.
Here’re some key takeaways:
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