What is hedging in stock markets? Everything you need to know

The views and opinions expressed are of Mr. Arun Thukral, MD & CEO, Axis Securities.

What is Hedging in Stock Markets?

Have you ever seen a hedge around a property? It acts as a natural wall or boundary of bushes or shrubs, protecting the property against intruders.

Figure 1: A hedge

Source: https://berserkon.com/img/get

According to the financial dictionary, hedging is a way of protecting oneself against financial losses or other adverse circumstances. Hedging in stock markets is done with the same objective: to protect your equity investment and limit losses. You may have seen a gardener taking care of a hedge, in a similar manner, hedging takes care of  your equity investments but you need to possess a few skills for the same. 

Hedging is like insurance for your equity investment

More often than not, as an investor in the stock market, you focus all your energy on earning profits and increasing the size of your portfolio. However, protecting your investments is just as important. 

What if the prices of some stocks in your portfolio plunge like a Northern Gannet diving straight into cold waters? 

That is where hedging helps you protect your investments. If you have invested in stocks, hedging acts as an insurance in an event where the price of the stock takes a steep fall. One example of hedging your equities against a fall in prices is by buying a Put Option.

Put Option? What’s that? We will explain that in a while.

What is hedging?

Hedging and speculation is a technique that protects a stock market investor from incurring huge losses in his investments. Basically, hedging involves doing the opposite of what you have done with your stock investments.

Figure 2: Hedging

Here’s how:

Assume that you have invested in ABC stock while it was trading at Rs. 300. You think that the company has good prospects and there’s nowhere to go but up. However, you are also aware that the stock market is unpredictable and the economy is going through a slowdown.

Therefore, to protect your investments, you buy a Put Option. A Put Option gives you the right to sell a stock at a specified price in the future. Also, to buy a put option, you don’t have to buy the stock; you only have to pay margin money - which is a fraction of the cost of the company’s shares.

For instance, you can buy a Put Option to sell the shares after 3 months at Rs. 290. Even if the price of ABC stock falls below Rs. 300, you can still sell the stock at Rs. 290 before 3 months and cut your losses. 

If the company’s share prices go up, you will make a profit in your stock investment and only lose a small amount of money paid as margin payment for the Put Option.

Apart from buying a Put Option, there are other methods of hedging employed by investors to mitigate losses; they include:

Asset allocation: In this strategy, the investor’s portfolio includes a variety of asset classes. For instance, you may invest 60% of your funds in the equity market and rest in fixed income or fixed return instruments to protect your wealth from volatility.

Structuring: Structuring allows an investor to invest a certain percentage of the portfolio in debt instruments and the remaining in derivatives. While debt instruments provide stability, derivatives act as a shield for your investments against big losses. 

Limitations of hedging

However, it’s also important to understand that hedging cannot prevent a negative event from happening. Hedging cannot protect you from a fall in stock prices; it only helps you to reduce the losses incurred due to fall in stock prices to an extent.

Hedging reduces risks as well as profit

In the above example, buying a put option of ABC shares will reduce your risk of losing money if the share prices go down. However, you also have to factor in the cost of margin money or the premium you paid to buy the Put Option if you make a profit.

Therefore, hedging not only reduces your risk but your profit as well.

3 Types of Hedging

FORWARD

FUTURES

MONEY MARKETS

4 Types of Hedging Strategies

Asset Allocation

Structures

Options

Staying in Cash

Advantages of Hedging

• Hedging in share market reduces your losses when share prices fall.

• With a small investment, one can insure a large amount of returns using hedging techniques.

• Hedging encourages investments as it significantly reduces risks associated with equity.

Equity investments are not free from risk and fluctuations in prices but hedging helps traders and investors protect their money from volatility and uncertainty. Hedging should ideally be used as a tool to mitigate risks rather than to make a profit.

Things to consider before hedging in equities

Before you use hedging as a tool to mitigate the risks of your investments, you should consider a few important things. For example, the cost of hedging should not be more than the profit you expect from your equity investments. Finally, you must be familiar with utilizing hedging strategies and tools to maximize its potential.

We aim to provide world-class and cost-effective retail broking and investments services as well as impart knowledge on equity investments, hedging and other financial tools. You can also visit Axis Direct for daily updates on stocks and financial news.

Sources:

1. https://www.investopedia.com/trading/hedging-beginners-guide/

2. https://cleartax.in/s/hedging-strategies