If you are someone serious in the Stock Market, you might have often come across the word Hedging. It’s a technique of Protecting your capital, assets, or valuables from unforeseen future risks or events. Applications of Hedging are not only limited to the Stock Market, it has a much wider impact on all financial aspects of our life and in Financial Planning.
In a broader sense, Hedging can be said to be the process of capping your loss or protecting your assets / investments from unforeseen circumstances. Most of us have noticed the hike in the Gold Price during the Covid-19 Pandemic Situation and might have heard of news saying that investors are taking money out of equity and pumping it in Gold. This is portfolio diversification and hedging method, where the investors try to minimize their loss in one asset class by increasing investment in a rising asset so that loss in one asset will get nullified or reduced with profits in the other.
Hedging is often said as an art in the Financial space, with a lot of concepts, theories, books written on it to help you excel in your world of investment. But in this article we will be focusing on the basic concepts and a few methods of Hedging your Equity Portfolio, the importance of Hedging in Stock Market and role of derivative instruments in Hedging.
We all know that Stocks or Shares possess a bit of downfall risk, if the economic conditions worsen or if the companies financial position weaken. The downfall risk due to management fraudulent actions will be really high, capable of wiping out our entire investment as we have seen in the case of Yes Bank recently. Retail Investors as well as Institutional Investors will get hit and crores of money can be lost in such scenarios. To protect the investors from such huge downfall risk and to facilitate the technique of Hedging the investors positions, the Derivatives segment was introduced, i.e. Futures & Options.
Futures & Options are heavily used derivative instruments, which despite having an inherent speculative nature is considered and referred to as Non- speculative instruments owing to its underlying concept of using as a Hedging Tool for your Equity Portfolio. Trading income from F&O segment is considered as Non-Speculative Business income under Indian Income Tax.
Both Futures and Options allow us to go Long or Short on the Underlying asset till the expiry period, which enables us to Hedge our position if the trade goes against our view.
Hedging Long term Equity / Futures with Put Option
This is one of the Predominantly used Hedging techniques by Long term Intelligent Investors, big retail and Institutional Investors. In this method the investor purchases a lot of Equity shares of an F&O Stock with a view of long term investment. To protect this stock from major downfall, the investor purchases a Put Option, either ITM or OTM, taking into account the maximum loss they could afford. By this method the long term investment position is hedged by having a Put option, which caps the maximum loss by compromising a slight amount from expected profit (Amount equivalent to premium paid).
Let’s look at an Example of Buying 1500 Quantity (1 Lot) Shares of SBIN at 360/- Rs, making the total investment of 1500 x 360 = 540,000/- Rs. and you plan to take a maximum loss of 15 Points only, ie 1500 x 15 = 22,500/- Rs on the trade. Placing a traditional SL of 15 points at 345 Rs will not be suitable in a volatile market where chances of hitting your SL is high. So one better option is to Buy 1 Lot of SBIN 350 PE (Put Option) of premium 5/- Rs per lot for a total premium of 1500 x 5 = 7,500/- Rs, thereby hedging your position effectively. Suppose if due to some bad news SBIN falls by 5% to 340 Rs, if you haven’t placed a SL or Pledged your Position you would have lost 1500 x 20 = 30,000/- Rs. But If you bought 350 Put Option, it will give you 1500 x 10 = 15,000/- Rs Profit, Effectively capping your loss to -30,000 (Stock) + 15,000 (Put Option) – 7,500 (Premium Paid) = 22,500/- Rs. Even if SBIN falls to 300 Rs, still you will face a loss of 22,500/- only [ (-60 x 1500) + (50 x 1500) – 7500] .ie whatever downfall happens to SBIN, you will see a maximum loss of 22,500/- only, if you have hedged your position. So as a long term investor who believes in the stock you could hold on to it as long as you wish to take maximum profit at a suitable time in future, when SBIN regains its bullish trend.
In the above Hedging technique we have used OTM Put Option where we don’t have to compromise much on our profits, the breakeven point was just 5 points away(SBIN at 365/-). If you wish to cap your losses even low, then you could consider ITM or ATM Options by sacrificing profits, which is not the ideal scenario.
The same Hedging method can be applied while going long on Futures as well, where you buy 1 Lot of Futures and Hedge it with a suitable Put Option. In such a case you could also take advantage of the margin requirement, ie buying 1500 quantity if SBIN required 5Lakhs+ but if you buy 1 Lot Futures of SBIN at 360/- Rs along with 1 Lot SBIN 350 PE at 5/-Rs you will have to pay nearly 50,000/- Rs only and enjoy the same Net payoff as shown above. That makes F&O on a Hedged manner highly lucrative, with a minimum capital you could earn equivalent to a 10x portfolio of equity.
While shorting Futures, you could consider buying a Call option to Hedge your position, to Cap your losses and enjoy the margin benefits.
One thing you might have noticed is that lot size should be maintained in the correct proportion on all asset classes, that’s why we considered buying 1500 Quantity (1 Lot of SBIN) in our example. Even retail individuals who could not afford to have such quantities, should also consider hedging with an appropriate put option to cap their losses in a systematic way by making an estimate of their payoff in multiple scenarios of hedging with an Option.
What we discussed here is a mere glimpse of the Hedging Process in the Stock Market, there are multiple Hedging techniques available in the market and you could also try and test various combinations of asset classes or instruments to make a Good Hedging Strategy for Yourself.
Good Luck and Happy Trading…!!!