Hedging is one of the most useful and important applications of Futures. Hedging can be used to protect your trading positions in the event of adverse market movements. I will try to explain hedging using an analogy.
Imagine that you have a little bit of barren land outside your home. Instead of seeing it as barren and uncultivated, you decide to enlarge the area and plant some nice flowers. Then you nurture your little garden and water it often. You can watch it grow. Your efforts eventually pay off, and your lawn becomes lush green and flowers begin to bloom. The wrong type of attention starts to be drawn to your garden as the plants and flowers grow. Your little garden soon becomes a popular spot for stray cattle. These stray cows are merrily grazing on the grass and destroying the beautiful flowers. This makes you mad and you decide to protect your garden. You have a simple solution: you build a fence around your garden, or a wooden hedge, to stop the cows entering. This small workaround will ensure your garden is protected and allows your garden to flourish.
Let's now apply this analogy to markets.
I trust you found the above analogy helpful in understanding what hedging is. Hedging, as I mentioned earlier is a way to protect your market position from adverse movements. You don't have to believe that hedging is only for protecting a portfolio of stocks. Hedging can be used to protect individual stock positions with certain restrictions.
When discussing hedging, a common question is "Why hedge a position? " This is what you might see. A trader or investor has a stock he purchased at Rs.100. He now feels that the market will decline, and his stock will follow. He has two options.
Let's first understand what happens when a trader decides to not hedge. Assume that the stock you have invested falls from Rs.100 down to Rs.75. As time goes by, we will assume that eventually the stock will rebound to Rs.100. The point is that if the stock moves back to its initial price, then why would one need to hedge?
You would agree that the 25% drop in price from Rs.100/– to Rs.75/– is a significant drop. The stock must move back from Rs.75/– to Rs.100/–, which is not a scale back by 25%. Instead, it has to move 33.33% to return to its original investment value. It is easier to drop the stock, but more work to get it back to its original value. Stocks don't rise as easily when there is a bull market. It is prudent to hedge positions whenever there is a significant adverse market movement.
What about the 2 and 3 options? The 2 nd option, where an investor sells the position to buy back the same at later stages, requires one to monitor the market. This is difficult to do. If the trader does not transact frequently, he may not be eligible for Long-term capital tax. Not to be forgotten, transaction fees are also charged for frequent transactions.
Hedging is a smart strategy because it virtually insulates the position and makes it indifferent to market events. It's almost like receiving a vaccination against a disease. The trader can hedge his position so that adverse market movements will not affect him.
Before we can understand how to hedge our market positions, it is important that we understand what we are trying to hedge. As you can see, we are protecting the risk. But what type of risk?
You are exposed to risk when you purchase stock in a company. There are two types, Systematic and Unsystematic risk. These risks are present when you purchase stock or stock futures.
Stocks can fall (and result in losses for you) due to many reasons. These reasons include:
These are all reasons that could lead to risk. However, there may be other reasons. But, if you look closely, all these risks are company-specific risk. Imagine that you have Rs.100,000. HCL Technologies Limited is the company you decide to invest your money in. HCL Technologies Limited announces that revenues have fallen a few months later. HCL stock prices will fall, which is quite obvious. This means that you will lose money on investment. This news will not affect HCL's stock price (Tech Mahindra and Mindtree), however. Tech Mahindra stock price will also drop if its management is found guilty of misconduct. These risks are unique to the company and do not affect other companies. These risks are sometimes called the " Unsystematic risk".
Diversification is possible to reduce unsystematic risk. This means that instead of investing all your money in one company, it's possible to choose diversification and invest in 2-3 other companies, preferably from different industries. Unsystematic risk can be greatly reduced when you do this. As an example, instead of purchasing HCL for its entire capital, imagine that you buy HCL at Rs.50,000/= and Karnataka Bank Limited at Rs.50,000/=. In such an instance, even though HCL stock prices decline (due to unsystematic risks), the damage is limited to half of the investment since the other half is invested with a different company. Instead of having just two stocks, you could have five stock, 10 or 20 stock portfolios. Your portfolio's diversification will be greater and your unsystematic risk will decrease the more stocks you have.
We are now faced with a crucial question: How many stocks should a portfolio have to ensure that unsystematic risk is fully diversified? Research suggests that a portfolio should contain at least 21 stocks to achieve the necessary diversification effect. Anything beyond 21 stocks could cause problems with diversification.
This graph should give you an idea of diversification - (image).
The graph shows that the unsystematic risks are greatly reduced when you diversify your portfolio and add more stocks. The graph begins to flatten after 20 stocks, indicating that the unsystematic risks are not easily diversifiable. The " Systematic risk" is the only remaining risk after diversification.
A systemic risk is a risk that affects all stocks. These are often macroeconomic risks that have a tendency to affect the entire market. Systematic risk can be summed up as:
The list could go on, but you should have a good idea of what constitutes systemic risk. All stocks are affected by systematic risk. If you have 20 stocks that are well-diversified, then a decline in GDP will surely affect all 20 stocks. They will all be likely to fall. The system is subject to systematic risk and cannot be diversified. But, systematic risk can be "hedged". Hedging is different from diversification.
We diversify to reduce unsystematic risk, and we hedge to limit systematic risk.
First, we will discuss how to hedge a single stock future. It's very easy and straightforward. Its limitations will be explained, and then we will discuss how to hedge a portfolio.
Imagine that you have purchased 250 shares of Infosys for Rs. 2,284/- each share. This amounts to an investment of Rs.571,000/. You are clearly long on Infosys's spot market. You realize that the quarterly results will be announced soon after you have initiated this position. Infosys could announce some unfavorable numbers which could cause a significant drop in stock prices. You can hedge your position to avoid a loss on the spot market.
To hedge the spot position, we can simply enter a futures market counter position. The spot position is'long' so we need to enter a counter position in the futures markets.
These are the details for futures trades.
Short Futures @ 2285/ -
Lot Size = 250
Contract Value = Rs.571,250/
Both you and Infosys are long (in the spot market), but short (at different prices) in Infosys' futures price. We are 'neutral so price fluctuations are not an issue. We will explain this in a moment.
Let's imagine a variety of price points for Infosys after initiating the trade and what the overall effect will be on the positions.
|Arbitrary price||P&L Long Spot||P&L for Short Futures||Net P&L|
|2200||2200 - 2284 = + 84||2285 - 22200 = +85||-84 + 85 = 1|
|2290||2290-2284 = +6||2285-2290 = -5||+6 - +1 =|
|2500||2500 - 2284 = +216||2285 - 2500 = +215||+216 - 215 =|
It is important to remember that no matter where the price goes (whether it rises or falls), the position will not make money or lose money. It's as if the entire position has been frozen. The position becomes indifferent towards the market. This is why we say that a position that is hedged stays 'neutral to the overall market conditions. Hedging single stock positions is easy and straightforward, as I mentioned. To hedge the position, we can use the stock futures contract. To use the stock's futures position, one must have the exact same number of shares and lot size. If they differ, the P&L may fluctuate and position won't be fully hedged. This raises some important questions.
The answer to these questions isn't really straightforward. Soon we will be able to explain how and why. We will now look at how to hedge multiple spot positions (usually in a portfolio). To do this, we need to first understand what " Beta” is about a stock.
Beta, denoted in Greek by the symbol "b", is an important concept in market finance because it can be used for many aspects of market financing. We are now at an ideal stage to introduce beta as it is also used in the hedging portfolio.
Beta is simply a measure of the sensitivity of the stock market price to changes in the market. It helps us answer these types of questions.
A stock's beta can have any value, greater or less than zero. The beta of market indices (Sensex, Nifty) is always +1. Let's say that beta of BPCL = +0.7. The following are implicit:
This table will give you an idea of how to interpret stock beta values.
|Beta is the value of a stock||Interpretation|
|Ex: -0.4||The -ve sign signifies that the stock price or market movement is in the|
opposite direction. If the market rises by 1%, then ve beta stock
Expect a decline of 0.4% in the value of -0.4
|Equal to 0||This means that the stock is not affected by market movements.|
The market fluctuation is unlikely to have an impact on the movement of the
Stock. Stocks with 0 beta are difficult to find.
|Greater than 0 and less than 1|
|This means that the stock and market move in the exact same direction.|
However, the stock is less risky than other stocks. A market move of 1%
The stock will rise by 0.6%. These stocks are often referred to as low beta stocks.
|Higher than 1, Ex: 1.2||This means that the stock moves in the exact same direction as the market.|
However, the stock tends move 20% faster than the market.
This means that if the market rises by 1.0%, then the stock is expected to increase.
To increase by 1.2% The stock will also rise if the market falls by 1%.
It is expected that it will fall by 1.2%. These stocks are commonly known as high beta stocks.
Here is the Beta value of a few blue-chip stocks as of January 2015.
|Stock Name||Beta Value|
|Axis Bank Limited||1.40|
Excel allows you to quickly calculate the beta value for any stock by using a function called "=SLOPE". This is how you calculate it step-by-step. I've used TCS as an example.
We will now return to the topic of hedging stocks portfolios using Nifty futures. But before we get started, you might be wondering why Nifty Futures are used to hedge a portfolio. Why not use something else?
Remember that there are two types of risk: systematic and unsystematic. A diversified portfolio naturally minimizes unsystematic risk. The systematic risk is what is left. We know that systematic risk refers to the risk associated markets. Therefore, the best way for market protection is to use an index that represents the market. The Nifty futures are a natural option to hedge against systematic risk.
Let's say I have Rs. 800,000/- invested in the following stocks:
|Sl No||Stock Name||Stock Beta||An Investment Level|
|02||Axis Bank Limited||1.40||Rs.125,000/ -|
|08||Maruti Suzuki||0.95||Rs.140,000/ -|
Step 1 - Portfolio Beta
Hedging a stock portfolio involves a few steps. First, we must calculate the "Portfolio beta" .
Below is a table that calculates the beta weighted for each stock in your portfolio.
|Sl No||Stock Name||Beta||Invest||Portfolio Weight||Weighted Beta|
|02||Axis Bank Limited||1.40||Rs.125,000/ -||15.6%||0.219|
|08||Maruti Suzuki||0.95||Rs.140,000/ -||17.5%||0.166|
The Portfolio beta is the sum of the weighted beta. The beta is 1.223 for the portfolio above. The portfolio is expected to rise by 1.223% if Nifty moves up by 1%. The portfolio will also be affected if Nifty falls by 1.223%.
Step 2: Calculate the hedge amount
Hedge value simply refers to the Portfolio Beta and total portfolio investment.
= 1.223 * 800,000.
This is a long-only portfolio. We have bought these stocks in the spot markets. We are aware that to hedge, we must take a position in the futures market. To hedge a portfolio worth Rs.800,000.00, we would need to short futures worth Rs.978.400/-. The portfolio is high beta and this should make it easy to understand.
Step 3: Calculate the required number of lots
Nifty futures are currently trading at 9025. With the current lot size being 25 lots, the contract value per lot is -.
= 9025 * 25
Therefore, the required number of lots to shorten Nifty Futures would be
= Hedge Value/Contract Value
= 978,400/ 225625
This calculation suggests that to hedge a portfolio worth Rs.800,000.00 with a beta value of 1.223, one must short 4.33 lots Nifty futures. We cannot shorten 4.33 lots. However, we can short 4 or 5 lots. Fractional lot sizes are not possible.
We would be slightly under-heated if we chose to shorten 4 lots. The same applies to 5 units. We would be more hedged. This is why we can't always hedge a portfolio perfectly.
Let's say that Nifty falls by 500 points after the hedge is in place. This would be approximately 5.5%. This will allow us to calculate the effectiveness and cost-effectiveness of the portfolio hedge. For illustration purposes, we will assume that we can shorten 4.33 lots.
Short initiated at -9025
500 Points of decline in value
Nifty value – 8525
Number of lots - 4.33
P & L = 4.33 *25 * 500 = Rs.54.125
The short position has earned Rs.54,125/. We will investigate what might have happened to the portfolio.
Portfolio Value = Rs.800,000/-
Portfolio Beta = 1.223
Market decline = 5.5%
Expected Decline in Portfolio = 5.5% * 1.233 = 6.78%
= 6.78% * 800000
= Rs. 54,240
As you can see, the short Nifty position has gained Rs.54125 while the long portfolio has lost approximately Rs.542,240. The net market position is unchanged, with no gain or loss (please ignore the small difference). The portfolio loss is offset by the gains in Nifty futures.
I hope this helps you to better understand how you can hedge your stocks portfolio. You should replace the 4.33 lots with either 4 or 5 lots, and do the same exercise.
Let's close this chapter by revisiting two questions we raised when we talked about hedging single stock positions. For your convenience, I will also repost it here.
You can hedge stocks even if you don't have stock futures. As an example, let's say you have Rs.500,000/– worth of South Indian Bank. To identify the hedge value, multiply the stock's beta with its investment value. The hedge value is calculated if the stock has a beta 0.75.
This will allow you to hedge your spot position by simply dividing the hedge value and the Nifty's contract price.
The 2 nd question is not answered. You cannot hedge small positions with a value that is significantly lower than Nifty's contract value. Options can be used to hedge these positions. When we discuss options, we will also talk about the same.