Hedge To Stay Afloat

Why Sell Quality Stocks When You Can Simply Hedge? 

Often wealth is eroded when market corrects. Investors panic and explore various options at the last moment. Karan Bhojwani along with Yogesh Supekar explain that a simple and consistent equity portoflio hedging strategy could be the panacea for mitigating risks in portfolio management during market downturns. 

Investing in the stock market is a risky affair. The ebb and flow in the market has even surprised the mavens and experts at regular intervals. However, many a time, we see investors helplessly watching the value of their stock portfolio melting away with every price downtick. During such a phase, the only solution they consider is to sell off their portfolio and sit entirely in cash. We are all aware that every year there are instances where markets witness a sharp drop and also every three to five years there is a big fall in the markets. But there is a way in which these phases of downturns in the stock markets can be tackled. Well, this is where hedging comes into play. 

What is hedging? 

Let us understand the concept with an example. Individuals opt for motor insurance as this motor insurance policy gives protection to the vehicle owner against damages to his/her vehicle. While in the stock market, there is no direct insurance policy available which protects you against the falling stock price, investors can deploy hedging strategy by using derivative instruments which will help them to protect themselves from any negative turn of event. 

There are a number of strategies one can use to hedge one's portfolio, but here we will discuss some of the portfolio hedging strategies that are simple yet effective. 

Protecting against risk using beta hedging with Nifty futures 

Let us assume that a person named Shiva owns a portfolio with current value of Rs22.50 lakh. The portfolio is well-diversified and is closely correlated to the Nifty index (means that the beta is 1.08). This implies that whenever the value of Nifty declines by one per cent, the value of the overall portfolio of Shiva will decline by 1.08 per cent. The Nifty is trading at 10,800. So how can Shiva hedge his portfolio? He may initiate a short position in the Nifty futures. The table below explains how many lots of Nifty future he can short so that his portfolio is hedged to an equivalent extent.Selling three lots of Nifty would help investor to keep his/her losses restrictive during the corrective phase. While, one can still hope to make gains as and when markets turn around. 

Hedging for investors having a single stock in their portfolio with the help of stock futures 

We come across investors who have been holding a single stock in their portfolio since many years and now wish to continue to hold their stock. However, they want to hedge as they know the market may witness some downfall. Let us say Pratik holds 3000 shares of stock named ‘AAA’ trading at Rs500. So Pratik wants to hedge his position with the help of stock futures. Since he is already long in the cash market and now he has to take a counter position in the futures markets, he needs to sell equivalent number of stock futures. Remember, stock futures are sold in minimum lot sizes, so you need to match your cash market position to the lot equivalents. Let us say the company ‘AAA’ has a lot size of 600 shares, so in order to make his position equivalent to his cash position, he needs to sell 5 lots (3000/600, i.e. total number of shares in the portfolio/shares in the lot size). Now assume ‘AAA’ in future markets is trading with a premium of Rs3 to the cash markets, hence the CMP would be Rs503. 

Now, on the one hand, Pratik is long on the stock in the cash market and, on the other hand, he is short in futures for the same stock with similar quantity. 

Let’s take a look at what happens when there is a fall and rise in the stock price and see what impact it has on the overall position. 

Looking at the above chart, it clearly indicates that irrespective of the drastic price moves, the final payoff is neither a substantial profit nor loss. Hedging for investors with the help of Put option: Let us say Chirag owns 1000 shares of a company named ‘XYZ’ and the stock is trading at Rs100 each. Chirag believes that the price of his stock will increase in future, but he wants to hedge against the risk of an unexpected price decline. He wants to hedge his stockholding by buying Put option of the stock. So he opts for buying an at-the-money (ATM) Put option, i.e. 100 strike price of ‘XYZ’. Let us assume the Put of strike price 100 is trading at Rs3 and the lot size is 1000. 

So, the total cost of hedging here is Rs3000 per lot. The breakeven point for the option would be Rs97 (100-3), i.e. strike price – premium paid. 

Let us now examine how the risk is limited by buying Put option (with other factors remaining the same). 

From the above table, it is clearly visible that even though the stock corrects about 25 per cent from its current market price of Rs100 to Rs75; the loss incurred would be limited. On the other hand, as the stock price surge higher it would help him to fetch a profit of Rs22 per share. 

Initiate Collar 

A collar is one the most popular methods of protecting portfolio value against a market decline. 

What is Collar option strategy? A collar is an option strategy that is initiated by holding stocks of the underlying asset, while simultaneously buying Put and selling Call options against the holding. The Calls and Puts are both out-of-the-money options having the same expiration date. 

Construction of Strategy: Let us assume Mitesh holds 2000 shares of ‘ABC Corp’ trading at Rs1000. Now, he wants to initiate a collar strategy. So, he sells out-of-the-money (OTM) Call of strike price 1050 at Rs18 and buys out-of-the money (OTM ) Put of 950 at Rs16. In this case, the break-even for the 950 Put option would be Strike Price – Premium Paid i.e. 950-16 = 934, while the 1050 Call option would be Strike Price + Premium received, i.e. 1050 + 18 = 1068 

The above table depicts the profit and loss at different levels of the stock price (with other factors remaining the same). 

Conclusion 

Investors in India are not used to the concept of portfolio protection. It is important for investors to understand the concept of hedging and assess if the objective of portfolio protection is being met while designing the portfolio hedge strategy. While adopting a portfolio hedging strategy, it is crucial to ascertain if any new risk is getting added and, at the same time, the costs of hedging should be comprehensively discounted. The hedging strategy should be simple and consistent. Investors should bear in mind that hedging cannot make losses go away, but it can help minimise losses. The aim should be to lose less in bad times, and not to aim for additional returns. 

Definitely, a natural hedge can be created for an overall portfolio by investing in different asset classes. However, when it comes to equity portfolio hedging, using derivative instruments is one of the best ways to protect your long-term portfolio. Derivative instruments such as options and futures can be optimally used to protect portfolio returns during bad times of the markets. With myriad hedging strategies available, it is easy for investors to lose focus. Investors can adopt select strategies mentioned above to minimise losses during market downturns.

Aasif Hirani
Director, Tradebulls Securities 

"Hedging is not to make money, but to protect from losses " 

How best can a long term investor hedge his or her portfolio? 

The basic objective of hedging is to reduce the risk. For long term investors, diversification is the key for hedging. For short term investors, one can hedge by using derivatives, namely options and futures. Spreading the wealth is one basic rule. Equities are wonderful, but one can't put all eggs in one basket. Spread your risk by hedging your portfolio with investment in other asset classes such as gold, ETF and debt. 

What are the common mistakes made by investors while hedging a portfolio? 

Failing to diversify enough is one of the common mistakes made by investors while hedging their portfolio. Another is letting emotions get in the way in order to chase higher yield or return. Also, investors give less preference to other asset classes. 

Is hedging expensive? 

Every hedge has a cost, so investors should ask themselves if the benefits received justify the expenses. Hedging is not to make money, but to protect from losses. For short term traders, trading in derivatives to hedge their portfolio is expensive as they will be incurring cost of option or future contract. 

What are the risks involved in hedging a portfolio? 

Debts are considered safe, but solvency of issuer is very important. Currently, many bondholders have to take hair cuts because of failure of payment by the debt issuer. Many investors hedge their equity portfolio with derivatives and sometimes the market is illiquid and that leads to transparency gaps in option pricing.

One has two options here. The first one is to bifurcate one’s long term portfolio into two parts - stocks intended for long term investing and those intended for short-term trading. The short-term trading portfolio can be managed with a trailing stop loss as an exit strategy. In the event of a market crash, one can conveniently take a timely exit. The second option is using derivative instruments of futures and options to hedge. In instances 

"How to hedge your portfolio during a downfall in the markets " Vishal B Malkan Author/Trading Coach, Malkansview 

where one is anticipating an eventbased decline, which is typically short-lived in nature, using options could be one of the best ways to hedge, especially the indices Nifty and Bank Nifty by using the Put options. In the instances of a slow and steady downtrend which is cyclical in nature, one may trade the Nifty futures on the short side. Also, using the strategy of covered call for specific stocks in your portfolio (that are part of the derivatives) could be one of the profitable strategies to create the hedge.