How Future and Options can be used for Hedging?
The word hedging may seem foreign to most people outside the finance world. Hedging simply means a strategy employed to offset losses in the market by taking an opposite view of your underlying portfolio. We, humans, are naturally risk-averse and engage in hedging principles without us being consciously aware of it. Life insurance is one such real-world example. We buy policies to support our family in case of an unfortunate event. This is a classic case of Hedging in the real world.
Why do we need to Hedge?
Now let us move to the stock market scenario, Let’s say you have been investing for a while and have amassed a decent portfolio. It may so happen that suddenly there is a lot of uncertainty in the markets probably due to an impending war or an economic breakdown. Given this uncertainty, your stock may decline. What can you do in such a situation? Ideally, in such a scenario, you, as an investor, are left with 3 options:
- Allow the stocks in your portfolio to plummet hoping that they shall recover in time.
- Book your profit/loss and exit your position.
- Hedge your positions.
Simply put, hedging is basically like taking a contrasting position in the derivatives market so that your portfolio is saved, in case of market volatility.
Sounds interesting right? Let’s now understand our choices to hedge our portfolio. We can mainly hedge in two ways:
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Hedging with Futures
Let us say you are long on a particular stock “X” in the spot market whose price is Rs 300/- and you are holding 5000 shares of the same. This would constitute a portfolio of Rs 15,00,000. After the position has been initiated, let’s assume there is a sudden fear gripping the global markets about a new deadly virus variant. One way in which you can hedge your position is by simply taking a counter position in the futures market. That is we short the stock “X” in the futures market.
Read more on Groww: What is short selling?
If the lot size of stock “X” in the future market is 1650 quantities, then we must buy 3 lots of future to match our 5000 quantities in the spot market. The contract value of this would come up to 1650*3*300 = Rs14,85,000. Although the contract value is too high, we would roughly need about 1/3rd of the contract value as margin to execute this counter hedged trade. That is to say, the margin required for this particular trade would roughly be around Rs 5,00,000. The margin here simply refers to the amount of money that is required to execute a particular trade.
Since Trading in Futures and Options entails unlimited risk, margin amounts are collected from the traders to reduce the risk of counterparty default.
Hedging with Options
Again let’s imagine a similar scenario wherein you are long on a particular stock “X” in the spot market. The price is Rs 100 and you are holding 15000 shares of the same which amounts to a portfolio of Rs 15,00,000.
Due to uncertainty about fear gripping the markets you ideally want to be in a situation wherein you do not want to lose money when the stock goes down and also you do not want to miss your profits if the stock rallies. Now in such a situation, one can buy put options of that particular stock in the derivatives market.
To hedge a single stock “X”, Let’s say we buy a Put option worth Rs 5 which expires in a month. This essentially translates to the premium which you are willing to pay to be immune to the downside risk for that particular month. If at all the stock plummets then your Put options will make you money thereby compensating your loss in the cash market.
However, if the stock rallies, the stock will make you money in the cash market and you will have a defined loss of Rs 5 in the derivatives market.
Let’s understand with 3 cases
We initially assumed that we bought the stock for Rs 100 in the cash market.
Case1: The stock price moves up to Rs 120
In such a situation, we make a profit of Rs 20 in the cash market since we had purchased the stock at a price of Rs 100 However, we shall lose the money which we paid to buy Put options which is Rs 5/- giving us a net profit of Rs 15.
Case2: The stock price plummets to Rs 80
In such a scenario, we shall have a loss of Rs 20 in the cash market and make a profit of Rs 15 in the derivatives market. Thereby making a net loss of Rs 5 which is the premium paid initially to buy the Put options.
Case3: The stock price remains unchanged at Rs 100
In the 3rd case, we shall have no gain or loss in the cash market. However, we shall lose the money paid as a premium essentially making a net loss of Rs 5.
What if your portfolio consists of multiple stocks and not just one?
In such a scenario we can’t short just a single stock. The concept involves taking a short position on NIFTY by calculating a value called portfolio beta which is slightly complex. More on this in our upcoming blogs.
The takeaway
Futures and options are financial derivatives that are used for hedging. The buyers and sellers seal a price for the underlying asset, removing uncertainty caused by fluctuations. Both of these are excellent financial tools that you can combine with other methods of mitigating risk in your portfolio. However, before you enter into a futures or options contract, you must understand how they work including the risks.