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How to hedge your market exposure

The word hedge refers to protection against unfavorable price movements.

SMEs, banks, foreign exchange, markets, forex, small and medium price industries,
SMEs at large do not understand forex and the concept of hedging, which banks often exploit. (Photo: iStock)
Sneha Seth Mumbai
Last Updated : Sep 03 2018 | 8:40 AM IST
What do we understand by the word hedge? The word hedge refers to protection against unfavorable price movements. It can involve protection against downsides if you are long on the market and protection against upsides if you are short in the market. In other words, hedging is nothing but an insurance against the volatility of your portfolio. You incur a cost to hedge but that also protects you against deep losses in a worst-case scenario. For the purpose of hedging, we shall only talk about long positions and not about short positions. There are 3 ways to hedge your exposure in the market when you are holding on to equity market positions as an investor or as a trader.

• Hedging with the use of stock futures
• Hedging with the use of long put options
• Protection with the help of Beta Hedging

1. How to hedge with the help of stock futures

In this case, you hedge your cash market position when the stock price goes down. Suppose, you bought Tata Motors at Rs.290! Due to problems with JLR, the stock price of Tata Motors may have fallen to Rs.280. How do you protect yourself, or at least, limit the damage? You can do that by selling the Tata Motors futures at Rs.280. By doing so, you lock in a maximum loss of Rs.10. Since you are short on futures you will be earning the positive spread each month on the positioning roll over. Now, you are totally immune even if the price goes down to Rs.240. Your maximum loss is limited to the difference between the spot price and the futures price (290-280). Below that point, whatever is your notional loss on your cash market position is compensated by profit on your short Tata Motors futures. 

From this level, there are two possibilities. The price of TAMO may correct to Rs.240, at which point if you are convinced of the support, you can book profits of Rs.40 on the TAMO futures. As a result, your cost of holding TAMO stock comes down to Rs.250 from Rs.290. Alternatively, TAMO could bounce up sharply. If TAMO bounces back then you can look to trigger stop loss on the short futures position after a decisive break out above resistance.

2. Using put options to hedge your equity risk

Assume that you are extremely positive on SBI but you also believe that in case of any repo rate hikes announced by the RBI or any worsening of NPAs of SBI, the stock could show weakness. The best way for you is to hedge the downside risk by purchasing a put option.

SBI – Bought at Rs.314 | SBI 310 put option bought at Rs.4 | Creation of a hedge on SBI
SBI Price Option price SBI mark to market SBI Put MTM Total Loss / Profit
335 0.25 +21 -3.75 +17.25
325 1.25 +11 -2.75 +8.25
305 7.25 -09 +3.25 -5.75
295 19.25 -19 +15.25 -3.75

In the above instance, the SBI equity market position has been hedged by buying a lower put option. What this put option assures you is that under no circumstance will the loss on your position be more than Rs 8 (314 – 310 + 4). On the upside, the profits are unlimited once you cover the premium cost of Rs.4. The only risk is that the put option hedge is a monthly cost and this will entail a cost each month.

3. Leveraging the power of Beta Hedging
 
The previous examples of hedging with stock futures and stock options are fine as long as you are holding 1 or 2 stocks in your portfolio. But, what if you are holding a portfolio of 8-10 stocks? In that case, individual hedging becomes cumbersome and hard to track. The answer is beta hedging. First, let us understand what is beta? Beta is a measure of systematic risk, which cannot be diversified away. A beta of more than 1 means that it is an aggressive stock and a beta of fewer than 1 means that it is a defensive stock. The beta of an index like Nifty is always 1. That is why when it comes to portfolios it makes more sense to do beta hedging. Let us understand how to beta hedge a portfolio of stocks.

Consider a portfolio of 5 stocks that you created

Serial Number Stock Name Stock Beta Investment Amount
1 Infosys 1.22 Rs.4,50,000
2 Reliance 1.15 Rs.5,50,000
3 Axis Bank 1.18 Rs.3,50,000
4 BPCL 1.45 Rs.6,00,000
5 Larsen & Toubro 1.25 Rs.2,80,000
    Total Value Rs.22,30,000

In the above case, you have created a portfolio worth Rs.22.30 lakhs consisting of 5 stocks in different proportions. Each stock has a beta (the measure of systematic risk) based on past price data. What do you understand when we say that Infosys has a Beta of 1.22. It means that the sensitivity of Infosys to movements in the Nifty is 1.22. That means if the Nifty is up by 1% then Infosys rises by 1.22% and if the Nifty goes down by 1% then the price of Infosys goes down by 1.22%. In our portfolio above, all the stocks are aggressive stocks as they all have a Beta of greater than 1. Let us see how this works out to calculate the portfolio beta.

Portfolio beta is the weighted average of individual stock betas

Stock Name Stock Value Stock Weight Stock Beta Weighted Beta
Infosys Rs.4,50,000 20.18% 1.22 0.2462
Reliance Rs.5,50,000 24.66% 1.15 0.2836
Axis Bank Rs.3,50,000 15.70% 1.18 0.1853
BPCL Rs.6,00,000 26.91% 1.45 0.3902
Larsen & Toubro Rs.2,80,000 12.55% 1.25 0.1569
  Rs.22,30,000 100.00% Weighted Beta 1.2622

Having calculated the weighted beta of the portfolio at 1.2622, the question is how exactly can you do beta hedging? To perfectly hedge this portfolio we need to sell futures equivalent to Beta times (X) portfolio value. This may sound complicated but it is actually simple
.
Calculation for beta hedging

Value of the Portfolio – Rs 22,30,000/-
Weighted beta of portfolio – 1.2622
Value of Futures to be shorted – Rs 28,14,706 (22,30,000 x 1.2622)
 
We know that futures are traded based on minimum lots.

The current lot size of Nifty 75 units and the Nifty spot value (as on 21st Aug 2018) is 11,570.

That means the approximate value of 1 lot of Nifty futures is Rs.8,67,750/-

So to perfectly hedge your portfolio you need to sell 3.24 lots of Nifty (28,14,706/8,67,750)

How to sell 3.24 lots of Nifty?

Obviously, you cannot sell fractional lots of Nifty so you will have to sell either 3 lots or 4 lots of Nifty depending on your view on the Nifty. You will not be perfectly hedged but this Beta hedging will help you to get as close to a perfect protection as possible.

The author is a derivatives analyst, Angel Broking. The views expressed are her own

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