Hedging Using Futures and Options

We do purchase insurance to shield ourselves from a probability of financial loss caused by an occasion. Hedging resembles insurance wherein a financial specialist or broker in securities exchange might want to decrease the risk he is exposed to. Every individual trading in stock market is also exposed to a certain risk. In the event of adverse market movements, hedging simply protects trading positions from incurring a loss. This can be best understood with an example.

Suppose, you have invested in a stock X for Rs 100 six months back and now it is trading at Rs125. You have an unrealized return of 25% on your investment. You expect the market to turn turbulent due to ongoing quarterly results season. You see a possibility of a fall in stock price in line with the broad market.

In this case, you have three options

1.    Take no action and let his stock decline with a hope that it will eventually bounce back

2.    Sell the stock and hope to buy it later at a lower price

3.    Hedge the position

In first case, there is no guarantee that stock may reclaim the current or higher levels in future. Also there is no clarity on how long the stock will take to reclaim to current price after a fall. While, the second scenario looks impressive but is difficult to follow practically. So now we are left with the last option of hedging our existing positions. Hedging insulates our position from the movements in the market. 

Hedging using futures

Imagine you have bought 1000 shares of ABC Ltd at Rs100 per share. Hence, your total investment here is Rs 1,00,000 (1000*100). After initiating, you realize that ABC Ltd is going to come up with an AGM. Now you are worried ABC Ltd may announce anything which may not be favourable for a stock, as a result of which the stock price may decline considerably. To avoid making a loss in the spot market you decide to hedge the position.

In order to hedge the position in spot, we simply have to take a counter position in the futures market. Since the position in the spot is ‘long’, we hedge for ‘short’ in the futures market.  In futures, ABC ltd is trading at Rs 101 and the lot size is 1000; here, your total contract value sums to Rs 1,01,100.

Now, on one hand, we are long on stock and on the other hand, we are short in futures for same stock. However, there is difference of Rs 1 in both the positions but any variation in price is a cause of concern as directionally we are ‘NEUTRAL’.

Hedging using options

We have discussed about options trading earlier. Now let us see how one can take hedging positions using options. Taking above example into consideration, we can hedge our long position in ABC Ltd by buying put option of ATM strike price. Suppose, 100 put is trading at Rs 3 and the lot size is again 1000. So, the total cost of hedging here is Rs 3000 (3*1000) and the Break Even Point for this option trade is 97 (100-3) ie. Strike Price-Premium paid.  In this case, you maximum risk is the premium amount you paid. Even though stock corrects 10% from current level, you may lose Rs 3,000 only.

We have just elaborated couple of illustrations on how traders can use to limit their downside as markets can be unpredictable at times. Hedging is just like a vaccine shot that works against a virus.  Hence, traders should always opt for hedging as and when required.