Hedging is one of the key strategies available in the stock market that allows investors to mitigate the risk exposure to an adverse movement within their stock investments. The idea behind implementing the hedging strategy is to offset their risk exposure and limit themselves from any downward movement in stock prices. One can hedge his/her stock investments with many different types of financial instruments such as futures, options, and other money-market instruments. Here, we will dig deeper into it and demonstrate some hedging examples elaborating hedging with futures, Nifty Futures, money-market hedge etc.
What is hedging using Futures?
Before understanding hedging using futures, you need to understand what is a futures contract? – It is a financial derivative or financial contract that obliges the buyer to buy and receive a particular stock or any other tradable financial security (underlying asset) at a predetermined price at a specific point in the future while the seller obliges to provide and deliver the underlying asset at the expiration date.
Investors employ the hedging strategy to hedge their stocks with futures to ensure their position in the stock market is not affected by any adverse movement. As the systematic and unsystematic risks encircling the investor, the hedging using futures can benefit investors to ‘hedged’ himself/herself against the systematic risk that cannot be diversified. Hedge stocks with futures contracts eliminate the uncertainty about the volatility in the future price of the underlying stock.
Hedging with Futures – Example
To hedge stocks using futures, let’s say have bought 4300 shares of Tata Motors at Rs. 150.50 per share. The overall investment would be of Rs. 647150.00. Clearly, you are in a ‘Long’ position on Tata Motors in the spot market. Once you into the position, you came to the realization that quarterly results of Tata Motors are expected soon or there is a macroeconomic risk of interest rate tightening that may affect the share prices of Tata Motors, as a result, the stock price of Tata Motors may decline in value. So, to mitigate that risk in the spot market, you decided to hedge your position.
In order to hedge your position in the spot market, you can simply counter it by taking a short position in the futures market. As you have taken a ‘Long’ position in the spot market, you will have to take a ‘short’ position in the futures market.
Tata Motors (Futures)
|Share Price||Rs. 151.00|
|Contract Value||Rs. 649300.00|
As you can see that there is a variation in price while long on Tata Motors in the spot market and short on Tata Motors in the futures market. However, it is not much of a concern since you are in a neutral position which you are going to understand soon.
After the impact, let us arbitrarily imagine different scenarios in the stock price of Tata Motors and see what will be the overall impact on your positions.
|Arbitrary Price||Long Spot P&L||Short Futures P&L||Net P&L|
|140||140 – 150.50 = -10.50||151 – 140 = 9||-10.50 + 9 = -1.50|
|155||155 – 150.50 = 4.50||151 – 155 = -4||4.50 – 4 = +0.50|
|160||160 – 150.50 = 9.50||151 – 160 = -9||9.50 – 9.0 = +0.50|
Now the point to note here is – irrespective of where the stock price move (whether it increases or decreases) your position will neither make money nor lose money. Here your position will be neutral without any market influence. This is how one can hedge stocks using futures. However, to hedge your position perfectly, you need to have the same number of shares as that of the lot size. If they vary, the overall Profit & Loss will vary too. If that happens, you will no longer be perfectly hedged.
Nifty Futures for Hedging a Stock Portfolio – Example
Let us now demonstrate an example of hedging a stock portfolio by employing Nifty futures. When it comes to offsetting the systematic risk on a stock portfolio, the Nifty futures is the natural choice to hedge and mitigate the risk.
Let’s suppose you have Rs. 7,00,000 rupees invested across following stocks –
|Stock Name||Beta Value (Monthly-Two Year Range)||Investment Amount (in Rs.)|
|Asian Paints Ltd.||0.598||30,000|
|Bajaj Auto Ltd.||0.895||1,25,000|
|Coal India Ltd.||0.964||1,80,000|
|Gail (India) Ltd.||1.20||65,000|
|Grasim Industries Ltd.||1.48||75,000|
|HCL Technologies Ltd.||0.704||85,000|
Step 01: Find Portfolio Beta
The first thing you have to do is to calculate the overall ‘Portfolio Beta’ by summing the weighted beta of each stock in your portfolio.
Weighted Beta = Individual stock beta * Weightage of respective beta
Weightage = Sum invested in each stock / Total portfolio value
|S. No.||Stock Name||Beta||Investment||Weight in Portfolio||Weighted Beta|
|01||Asian Paints Ltd.||0.598||30,000||4.3%||0.026|
|02||Bajaj Auto Ltd.||0.895||1,25,000||17.9%||0.160|
|03||Coal India Ltd.||0.964||1,80,000||25.7%||0.248|
|04||Gail (India) Ltd.||1.20||65,000||9.3%||0.111|
|05||Grasim Industries Ltd.||1.48||75,000||10.7%||0.159|
|06||HCL Technologies Ltd.||0.704||85,000||12.1%||0.085|
As we can see, the overall Portfolio Beta is 0.851. Let say, the Nifty index goes up by 1 per cent then the stock portfolio is expected to go up by 0.851 per cent and vice-versa.
Step 02: Calculate Hedge Value
Now that you have the correlation between the Nifty index and your stock investment portfolio, it is time to calculate the hedge value which is as:
= 0.851 * 7,00,000 = Rs. 5,95,700
Remember, the stocks you have in your portfolio is in the spot market and your current position is ‘Long’. So, Nifty Futures Hedging against your stock portfolio will be a ‘Short’ position in the futures. The hedge value of Rs. 5,95,700/- suggests to short futures worth Rs. 5,95,700/-.
Step 03: Calculate the Lot Size
At present, the Nifty Futures (one-month) is trading at 11834, and with the current lot size of 75, the contract value per lot will be –
= 11834 * 75
= Rs. 8,87,550/-
Hence, the number of amounts required to short Nifty Futures would be
= Rs. 8,87,550/-
As you can see that to perfectly hedge your stock portfolio, you would require the extra amount of Rs. 2,91,850 to buy 1 lot of Nifty Futures. If that amount is less than your hedge value then you will be under hedged but as in this case, if you hedge yourself, then it would be over hedged. Therefore, we cannot always perfectly hedge the stock portfolio.
If the hedge value and portfolio value was close, then similar to the previous example, there be no loss or gain except a minor difference that can be ignored. But, if you continue with the imperfect hedging like under-hedged or over-hedged then you may bear some loss or make some profits out of your net position. But, that would offset the purpose of hedging to neutralize the adverse movement in stock prices.
But, truth is, no one can hedge small positions whose value is relatively lower than the value of Nifty Futures. However, to hedge such positions one have to hedge by employing Nifty Options.