Futures: Hedging & it’s importance

HEDGING.

Imagine this situation- you just bought a fundamentally good stock at a bargain. You know that you’ve done your home work and have bought the share at the right price and time. But still, in a surprise move, the market may think other wise and would send the stock price crashing. You may not even understand why the stock price tumbled. Such pitfalls are common in stock markets.What a weird place to be. isn’t it?

Now, is there a way to protect your money in such cases?

Yes ! There are many methods. One such method is to use futures to hedge your position. Before we explain that, let’s understand the meaning of hedging. Hedging is any act that trys to protect an investment from price risk to the maximum extend possible.So, it’s just like insurance. We insure our life - against death , against serious health problems, don’t we? But, we don’t take insurance for cold & cough. Similarly, hedging is not a strategy to employ for small investors because of the cost and effort involved. Hedging is effective when your investment involves a substantial amount.

HEDGING WITH FUTURES.

To hedge with futures, just take the opposite of the position taken in the spot market. i.e. if you are long in the spot market, short futures. If you are short in the spot market, go long in futures.

If the price in spot market falls, you lose in spot and gain in futures. If the price in spot market is up, you gain in spot and lose in futures. Either way, you would gain in one market and lose in the other. This never guarantees a huge return but it helps you to offset the loss incurred in a position and eliminates the price risk.

EXAMPLE.

  • 1. You bought 2000 shares of ICICI currently trading at Rs 700. Since the market is turbulent you fear that the stock price would fall and hence want to protect your investment from price risk. Futures of ICICI can be bought or sold at Rs 710. What would you do to hedge your position?

SHORT HEDGE – Sell 2000 shares of ICICI futures. Let’s assume that the stock price falls to Rs 670 and consequently, the futures too, falls to Rs 673.  You lose Rs 30 per share in the spot market and would gain Rs 37 (Rs 710-673) per share in the futures market.

Contrary to what’s said above if the stock price in the spot market rise to Rs 730, with futures trading at Rs 733, you would gain Rs 30 per share in the spot and lose Rs 23 per share in futures. Either way, you stand to gain Rs 7 per share. Your gain from the deal is Rs 14,000 (2000 x Rs 7) minus brokerage.

  • 2. You’ve shorted 1000 shares of HDFC currently trading at Rs 500. But soon after, some good news hits the market and the sentiments seem to be in favor of HDFC. You fear that the price in the spot market may go up and hence, want to protect your money to the maximum extent possible. Futures of HDFC are available at Rs 505. What would you do to hedge your position?

LONG HEDGE – Buy 1000 shares of HDFC futures. Let’s assume that the stock price is at Rs 525 and consequently, the futures trade at Rs 530. You lose Rs 25 per share in spot market and gain Rs 25 per share in futures. You nullify the effect of price that went against your calculations.

Now, suppose, there was no such good news and the stock price comes down as expected. HDFC now trades at Rs 475 and futures are trading at Rs 480. You gain Rs 25 in the spot market and lose Rs 25 in the futures market. So again, you nullify the effect of price fluctuations.

PERFECT HEDGE AND CROSS HEDGE

If a position taken would eliminate the risk of an existing position, or if a position can eliminate all the market risk from a portfolio of investments, it is called a perfect hedge.  In order to be a perfect hedge, a position would require a 100% inverse correlation to the initial position. Such positions are a rarity. Any hedge that’s not perfect is called an imperfect hedge.

In real life, it may so happen that the asset which is being hedged may not have a corresponding contract in futures segment. For example, futures are not available for A ltd, in which you hold 5000 shares. After a lot of observation and research, you find that A ltd’s shares moves in tandem with another company in the same line of business, B ltd. B ltd’s futures are available for trade. So, in order to hedge your position in Altd, you can go short on B ltd. Such a hedge is called Cross hedge.

FULL HEDGE AND PARTIAL HEDGE.

We don’t think there’s much to explain here. Full hedge is when you take exactly equivalent opposite position in order to protect 100% of your portfolio. Partial hedge is when you decide to hedge only a part of your holdings against risk. For example, an investor may be confident in 25% of his investments in blue chips, but may fear about the price risk of the other 75% invested in midcaps and small caps. Hence he may decide to hedge only 75% of his holdings.What he has done is called partial hedge.

That’s the basics for you. The purpose of this post was to explain hedging.  In real life, however, it may not be possible to create a perfect hedge due to various reasons. Hedging decisions are not simple as it is explained in this post. It’s also not totally risk free as we saw in the examples. The reason lies in a concept called ‘basis risk’ – coming up in our next article.

You may like these posts:

  1. Futures: Principles of pricing.
  2. Futures: Arbitrage & its meaning.
  3. Futures: Understanding the basic terms

7 Responses to “Futures: Hedging & it’s importance”

Tanya

May 15, 2012 at 10:49 pm

Hi dear, the way you expressed your thoughts were amazing. Very simple language you used. I understand why hedging is very important especially for huge portfolio users.

Jabir

May 16, 2012 at 8:16 pm

wonderful article. thnx victor !!!

Liya Thomas

May 17, 2012 at 7:49 am

Hi
Nice write up. I am a regular reader of this blog. The best part i’ve always noticed in your articles is that it’s written in a very simple language , it carries a lot of examples and at the same time it does handle the subject in depth.
keep it up. waiting for more.

J Victor

May 17, 2012 at 7:51 am

@ Tanya, jabir , Liya thomas. Thankyou.!!

saad

September 30, 2012 at 1:41 am

I have gone through many sites but could not understand derivatives in full depth and gave up. Later, i was going through the queries to the expert in one of my paid stock subcription site enquiring about reliability of your site and that is the day i have learnt about your site. I am extremely thankful to you for the information that has helped me to learn the Derivatives without any hassle.
I hope you will continue this excellent work.

J Victor

October 1, 2012 at 8:19 am

thanks for your words. :)

Ankit

March 15, 2013 at 10:47 pm

Discussed Above (“SHORT HEDGE”-point no 2), u r assuming to sell the shares in spot market. Does it possible to short sell the shares in spot market for more then 1 day?

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