This is a method of hedging through which one protects his/her investments against market risk by short-selling index futures. This is used by those who understand how to trade in derivatives. Portfolio insurance is essential for investors having a high market exposure and are, hence, more vulnerable to market related risks. Hedging risk by investing in futures or, short selling, is a widely practiced norm, and is currently the best form of protection one can get against market crashes in India. A market crash can technically wipe out any investment, and insuring portfolio is the only guarantee one has so that the losses do not go beyond a certain level.
Why do you need it?
Assets like house, car, jewellery, etc can be insured through insurance products. However, those like shares and mutual fund investments have no insurance policies in India. When markets turn volatile and fall unexpectedly, like we recently witnessed, investors record major losses with nothing to protect them from the freefall. This is when hedging your market risk, or insuring your portfolio by investing in futures, becomes a key part of your investment strategy.
How does it work?
If you have invested in company stocks forming a major part of an index or in equity-based mutual fund schemes, and wish to hedge your market risks, all you have to do is invest in the futures of that index, or if it is just one big company you have invested in, you need to invest in the futures of that stock.
For example, Rahul invested Rs 5 lakh in an equity mutual fund in December 2010. He wanted to invest for six months, while the Nifty was at the 6,000. To insure his portfolio against risks, he invested Rs 5,000 in Nifty 6000 PE trading at Rs 100, (lot size of 50*100). Currently, the Nifty is at 5,400. The markets have fallen by 10 per cent and so have his investments. Loss in investments equals Rs 50,000. However the profit made from the Put option is 50*600 (6,000-5,400) Rs 30,000. This reduces his overall loss to Rs 20,000 (50,000-30,000). Hence, a small investment of Rs 5,000 on an investment of Rs 5 lakh acted as portfolio insurance for Rahul, saving him Rs 25,000 in losses.
Is there a downside?
Portfolio insurance investments like futures work well when the markets go down. However, when they are up or remain at the same level, the futures investment eats into the profit or adds an additional loss to the investment. Though considering the amount spent on an investment and that on its protection, which need only be 1-5 per cent of the investment, it isn’t all that bad, even if one were to lose that amount.