How is hedging done in the stock market?

An investor can protect himself/herself from the risks i.e. hedge their positions, from the volatility of the stock market by various means.

· 3 min read
How is hedging done in the stock market?

Hedging is the act of protecting your underlying investment in case of a massive fluctuation in value in one direction by betting on the same underlying in the derivatives market in the other direction of the movement. Note that hedging is not a money-making strategy, rather it is a money-protecting strategy. Hedges are meant to remove only a portion of the exposure risk and no hedge can protect you from losses completely. A good portion of HNIs (high net-worth individuals) use derivatives to hedge their positions in the underlying itself.

In today's world of finance, trades, and investments, nearly anything can be hedged - equities, interest rates, commodities (like crude oil, silver, natural gas, etc), currency exchange rates, etc. In this article, we will be specifically covering the hedging of your equity portfolio.

It's natural for an investor, no matter how long-term their holding period is, to be scared or frightened by short-term movements in the stock market. It's easy to tell them "so what if it falls today, it'll go up eventually" and that is unlikely to comfort them. Such an investor can protect himself/herself from the risks i.e. hedge their positions, from the volatility of the stock market by various means:

a) Put option:- A put option is a contract giving the buyer of the option the right, but not the obligation, to sell the stock at the strike price he/she bought the option at. If the value of the underlying stock falls, then the value of the put option goes up.

For example, say you bought shares of Reliance Industries at Rs. 2000 in the spot market and bought put options (i.e. the value of this derivative will go up if the value of the underlying goes down) at a strike price of Rs. 1950. In case the value of your equity shares fall to Rs. 1900, then you can limit your loss of Rs.100 to just Rs. 50. The action of buying the Reliance Industries put option works like insurance against your bet on the underlying Reliance shares.

b) Short selling futures:- Another choice you have in this scenario will be short selling Reliance Industries futures. However, this can be difficult as position sizing on futures can be tricky and cumbersome, especially for most retail investors. Put options can be purchased at a cheaper price per lot with your existing capital, while the lure of highly leveraged trades in shorting futures could potentially wipe out any profit you make in the spot market, possibly even causing a margin call. This can cause your 'hedge' to destroy your account - this is the investing equivalent of a person going broke paying their term life insurance premiums.

If you would like to hedge your overall portfolio, it could be painful to buy a put option or sell the futures of each stock you own. A neater solution would be to buy the put options or sell the futures of the index containing the companies you would like to hedge.  For example, if you would like to reduce risks against a diversified portfolio, you can buy put options of the Nifty index itself. If you would like to reduce risks against your banking stocks, it will be much more convenient to short BankNifty futures or buy BankNifty put options than buy put options of every single banking stock in your portfolio.

If you do not have a portfolio as such to hedge, you can also hedge your long position on Nifty futures hedged with Nifty put options of the same expiry date, or even do the opposite with a short position on Nifty futures with Nifty call options of the same expiry, if you are bearish on the economy. The possibilities of trade ideas are limitless!

However, as mentioned before, the concept of hedging is not a god-sent money-minting strategy with absolute minimum risk. Maintaining hedges can be difficult and complicated. It is expensive to keep buying options to hedge in the long term as these contracts keep expiring. These hedging strategies can also limit return potential even in the scenario of your initial trade working out favorably. Most crucially, as mentioned earlier, any hedge that involves shorting has the risk of eating up any profits or even destroying your capital if the trade goes favorably.

If you perform your research with care and precision, you will be a lot more stress-free regarding your investments. Even if your investment does fall in value, you will still retain the same number of shares and you have the choice of doubling down on your underlying, generating possibilities for a much higher long-term return!

Related Articles

Crypto Staking | A beginners guide
· 3 min read
Evaluating Crypto Liquidity Pools
· 2 min read
Top 10 most promising crypto projects
· 5 min read
What are flexicap funds?
· 2 min read