What is Hedging ?

In order to understand what is Hedging or to become a hedger first of all we need to know hedging analogy in normal life . However book definition says ‘It is an kind of investment to reduce the risk of adverse price fluctuations in an asset ‘. A hedge can be made from many types of financial instruments, including stocks, insurance, forward contracts, swaps, options, futures contracts. Hedging in a way helps you to protect your trading positions from making a loss.

What hedging means?

Hedging is a Skill to safeguard your position in the market, so it does not get affected by any adverse movements. To get a better understanding let us consider a situation:

A test cricket match is being played. India won the toss & elected to bat first, however the opening pair did not performed and opposite team got early breakthrough. After few sessions again we lost 2 major upper order batsmen. Now its tea time, Team India decided instead of sending another batsmen for the day, will send a bowler with little batting knowledge also known as Nightwatchman.

Team does not want to risk his remaining batsmen for the day, if gets succeeded they can keep there best batsmen for tomorrow. This will ensure team have enough options to take risks when match will resume tomorrow .

Now let us understand this in terms of hedging .

Suppose you are the owner of a share Punjab national Bank (captain). Currently that share is trading at Rs. 100 however there is some internal changes happening in management, moreover bank also failed to give good quarterly results. Now this made the price of stock to fall. Next day Share plunged at Rs. 80 This is 20% down. Now what you can do in these situation considering the above cricket example :

  • No action as you believe it will eventually bounce back .(Make No changes in batting position )
  • Sell the stock & buy it back later at a lower price . ( Think Batsmen’s will try best in second innings)
  • Hedge the position (Allowing Nightwatchman)

What one exactly want to do while hedging is minimizing the risk. Whenever you buy any stock you have exposed yourself in market. There are n number of risks in market but if you have two categorize it there are 2 main risks involved while trading & Investing .

  • Systematic Risk :

    This kind of Risk is standard to all stocks. These are commonly the macroeconomic risks & leave its impact in whole market. Reduction in GDP,Geo political risk ,Higher Interest rate ,Higher Inflation ,Fiscal deficit etc.

 

  • non-systematic risk :

    This type of risk include dramatic events such as a strike, plunging revenues ,Higher financing cost ,Declining profit margins , a natural disaster such as a fire, or something as simple as Management misconduct or slumping sales. Two common sources of unsystematic risk are business risk and financial risk.

However non-systematic risk can be diversified, So instead of investing all your money in one company, you can choose to diversify and invest in 3-4 different companies (ideally from different sectors). When you do so, unsystematic risk is drastically reduced.

 

How to Hedge a Stock ?hedging

Let us see how one can hedge his stock bought from spot market by making a counter position in the futures market. Suppose for instance you bought 2000 shares of TATA MOTORS at Rs.200. Now, the total investment made is about Rs. 400,000.

As we have discussed earlier about the non-systematic risk, Tata Motors because of its subsidiary JLR facing huge problem. JLR is a worry for Tata Motors and the domestic market may not necessarily help in providing a edge against the JLR’s poor performance. Due to which the stock price may decline to a notably large extent. In order to avoid making loss you decided to hedge the position .

As our position in Tata Motors were Long earlier to hedge we have to short in Futures .

Short futures trade we need to apply –

Short Futures @ 200/-

Lot size = 2000

Contract Value = Rs.400,000/-

Now regardless of what price movement happens in spot price, the position will remain same. The overall position of stock would be frozen. Understand this, in order to hedge stocks one must have the same number of shares as that of the lot size. Otherwise the position will either be under hedged or over hedged. The stock P/L will look like this :

Random Price Long P&L Short Futures P&L Net P&L
228 228 – 200 = + 28 200 – 228 = -28 +28 -28 = 0
180 180 – 200 = -20 200 – 180 = +20 -20 +20  = 0
210 210 – 200 = +10 200 – 210 = -10 +10 – 10 = 0

As you see the overall impact on Profit & Loss is same. One more thing to consider here, you cannot hedge small positions whose value is Comparatively lower than the contract value of futures stock. Because the lot size for futures should match at-least the spot total value of a stock. However you can hedge such positions by employing options contracts .

What are the hedging strategies?

  • Systematic risk does not only impact stock of one sector or any particular company. It effects the whole market, hence this can’t be diversified, Hedging is the only option to avoid losses or sell the stock if you cannot bear the losses. Now to hedge for a systematic risk problems one has to adopt a strategy. Nifty futures, as an Index it contains stock from all the sectors which represent the market. In this case you can consider shorting Nifty Futures. However ,you can keep the stock if you are a long term investor .

 

  • non-systematic risk limited to a stock, that’s why we can diversify our portfolio and minimize the losses. Always try to diversify by buying stocks from different sectors. Moreover do not make diversification in one portfolio to be more than 20 stocks.

We would be Making a another blog on Beta (β) which also plays a crucial role in Hedging. We would be learning how to calculate it and use it as an strategy to maximize your profits. Till than go through our other important blog on asthatrade. If you have any question please feel free to ask in comments box below.

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