You must have often heard the term ‘hedging’ and its importance in investments. Although your investments may be performing well, a reversal in trend or any unforeseen event could negatively impact your portfolio. However, if you have hedged your investments, the downside can be limited. In this blog, we will go over how investors can protect their investments by hedging with futures.
To learn how to effectively hedge using futures, it is vital to learn what hedging is. Hedging refers to an activity through which investors can protect their positions from any adverse price movements. They can hedge their positions by investing in alternate assets such as gold or by taking an opposite position in a different instrument, which can help mitigate losses.
Strategic investment decisions can help investors hedge their positions. The gains from one asset or financial instrument can help offset or reduce the losses of the other asset.
Now that we know what hedging is, let’s take a look at how to hedge your positions using futures.
Futures are financial contracts between two parties to buy or sell an asset at a future date at a predetermined price. Futures derive their value from the underlying asset. The value of a futures contract increases with a rise in the value of the underlying asset and decreases with a fall in the value of the underlying asset.
Now, let’s look at how investors can hedge their investments using futures.
Imagine an investor has a portfolio comprising Nifty 50 stocks. However, the investor expects that future market conditions will be unfavourable and will result in a decline in the value of his investments. To hedge his portfolio, the investor can short the Nifty 50 futures. By short-selling the futures, the investor will benefit as the value of the futures contract declines. The gains from the short position in futures will offset the losses in his portfolio.
Suppose the investor’s portfolio was valued at Rs 5,00,000. In the next month, the market trended downwards, which reduced the portfolio’s value to Rs 4,50,000. However, the investor had a short position in Nifty 50 futures. As the Nifty 50 trended downwards, the value of the Nifty 50 futures contract also reduced in value which helped the investor pocket gains of Rs 45,000.
By hedging with futures, the investor mitigated the impact on his portfolio.
Portfolio Loss – 5,00,000 – 4,50,000 = 50,000
Gains from Futures = 45,000
Net Loss = 50,000 – 45,000 = Rs 4,500.
We can see that if the investor had not hedged his position, his portfolio would be down by Rs 50,000. However, the hedge reduced the loss to Rs 5,000.
Future contracts allow one to lock in prices which in turn act as a hedge. Buyers and sellers of an asset or a commodity make use of futures for forward hedges. Let us try to understand short and long hedges better with the example of a cotton farmer and a cloth manufacturer.
A short hedge is used by a seller when they expect a decline in prices. For example, a cotton farmer expects that the price of cotton will decline in the next harvest season due to poor weather conditions or an oversupply of the commodity. As a result, the farmer will sell futures contracts at Rs 1,000 to lock in the selling price.
In the next harvest season, the price of cotton declined to Rs 900. However, the farmer sold the future at Rs 1,000 allowing him to offset the losses. In case, the price had risen to Rs 1,100, the gains from the physical commodity would offset the losses from the futures contract.
A long hedge is used by buyers when they expect prices to rise in the future. The cloth manufacturer expects the price of cotton to rise next year. As a hedge against rising prices, the cloth manufacturer will buy a futures contract at Rs 1,000 to lock in the price.
The price of cotton increases to Rs 1,100 in the next year. Since the cloth manufacturer purchased the futures contract at Rs 1,000, the gains from the futures contract will offset the higher cost of cotton. In case the price of cotton falls in the next year, the cloth manufacturer would witness losses in his futures position but the lower price of cotton would offset the losses.
The following are the risks associated with hedging using futures.
Basis risk: A basis risk occurs when the price of the futures contract does not move in tandem with the underlying asset. This occurs due to different market locations, different commodity qualities, or settlement timings.
Liquidity risk: Hedging using illiquid futures can lead to challenges while exiting or entering positions at a fair price.
Market risk: The market risk occurs when futures contracts see a significant move in price, resulting in price gaps.
Operational risk: Operational risk refers to the risk of managing the hedge which includes entering, exiting, and monitoring the position.
Rollover risk: At times a futures contract needs to be rolled over to the next expiry. While rolling over to the new expiry, price discrepancies may occur resulting in a rollover risk.