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In the event of any adverse market movements, hedging is a simple work around to protect your trading positions from making a loss. Let me to attempt giving you an analogy to help you understand what hedging really is. Imagine you have a small bit of vacant barren land just outside your house, instead of seeing it lie vacant and barren you decide to lawn the entire plot and plant few nice flowering plants. You nurture the little garden, water it regularly, and watch it grow.
Eventually your efforts are paid off and the lawn grows lush green and the flowers finally start to blossom. As the plants grow and flowers start to bloom it starts to attract attention of the wrong kind. Soon you realize your little garden has become a hot destination for a few stray cows. You notice these stray cows merrily gazing away the grass and spoiling the nice flowers. You are really annoyed with this and decide to protect your little garden? A simple work around is what you have in mind — you erect a fence maybe a wooden hedge around the garden to prevent the cows from entering your garden.
This little work around ensures your garden stays protected and also lets your garden flourish. Like I had mentioned earlier, hedging is a technique to ensure your position in the market is not affected by any adverse movements.
A common question that gets asked frequently when one discusses about hedging is why really hedge a position? Imagine this — A trader or an investor has a stock which he has purchased at Rs. Now he feels the market is likely to decline and so would his stock. Given this, he can choose to do one of the following —. Firstly let us understand what really happens when the trader decides not to hedge. Imagine the stock you invested declines from Rs. We will also assume eventually as time passes by the stock will bounce back to Rs.
So the point here is when the stock eventually moves back to its original price, why should one really hedge? Well, you would agree the drop from Rs. However when the stock has to move back from Rs. This means when the stock drops it takes less effort do to so, but it requires extra efforts to scale back to the original value. Also, from my experience I can tell you stocks do not really go up that easily unless it is a raging bull market.
Hence for this reason, whenever one anticipates a reasonably massive adverse movement in the market, it is always prudent to hedge the positions. But what about the 2 nd option? Well, the 2 nd option where the investor sells the position and buys back the same at a later stage requires one to time the market, which is not something easy to do.
Besides when the trader transacts frequently, he will also not get the benefit of Long term capital tax. Needless to say, frequent transaction also incurs additional transactional fees.
For all these reasons, hedging makes sense as he is virtually insulates the position in the market and is therefore becomes indifferent to what really happens in the market.
It is like taking vaccine shot against a virus. Hence when the trader hedges he can be rest assured the adverse movement in the market will not affect his position. Before we proceed to understand how we could hedge our positions in the market, I guess it is important to understand what is that we are trying to hedge. Quite obviously as you can imagine, we are hedging the risk, but what kind of risk? When you buy the stock of a company you are essentially exposed to risk.
In fact there are two types of risk — Systematic Risk and Unsystematic Risk. When you buy a stock or a stock future, you are automatically exposed to both these risks. All these reasons represent a form of risk, in fact there could be many other similar reasons and this list can go on. However if you notice, there is one thing common to all these risks — they are all company specific risk.
For example imagine you have an investable capital of Rs. Few months later HCL makes a statement that their revenues have declined. Quite obviously HCL stock price will decline. Which means you will lose money on your investment. Clearly these risks which are specific to the company affect only the company in question and not others. Unsystematic risk can be diversified, meaning instead of investing all the money in one company, you can choose to diversify and invest in different companies preferably from different sectors.
When you do so, unsystematic risk is drastically reduced. Under such a circumstance, even if HCL stock price declines owing to the unsystematic risk the damage is only on half of the investment as the other half is invested in a different company.
In fact instead of just two stocks you can have a 5 stock or 10 or maybe 20 stock portfolio. The higher the number of stocks in your portfolio, higher the diversification and therefore lesser the unsystematic risk.
This leads us to a very important question — how many stocks should a good portfolio have so that the unsystematic risk is completely diversified. Research has it that up to 21 stocks in the portfolio will have the required necessary diversification effect and anything beyond 21 stocks may not help much in diversification. As you can notice from the graph above, the unsystematic risk drastically reduces when you diversify and add more stocks.
However after about 20 stocks the unsystematic risk is not really diversifiable, this is evident as the graph starts to flatten out after 20 stocks. Systematic risk is the risk that is common to all stocks. These are usually the macroeconomic risks which tend to affect the whole market. Example of systematic risk include —. Of course the list can go on but I suppose you got a fair idea of what constitutes systematic risk.
Systematic risk affects all stocks. So assuming you have a well diversified 20 stocks portfolio, a de-growth in GDP will certainly affect all 20 stocks and hence they are all likely to decline. Systematic risk is inherent in the system and it cannot really be diversified. So when we are talking about hedging, do bear in mind that it is not the same as diversification. We will first talk about hedging a single stock future as it is relatively simple and straight forward to implement.
We will also understand its limitation and then proceed to understand how to hedge a portfolio of stocks. Imagine you have bought shares of Infosys at Rs. This works out to an investment of Rs.
After you initiated this position, you realize the quarterly results are expected soon. You are worried Infosys may announce a not so favorable set of numbers, as a result of which the stock price may decline considerably. To avoid making a loss in the spot market you decide to hedge the position.
In order to hedge the position in spot, we simply have to enter a counter position in the futures market. Now on one hand you are long on Infosys in spot market and on the other hand we are short on Infosys in futures price , although at different prices. You will shortly understand what this means. After initiating this trade, let us arbitrarily imagine different price points for Infosys and see what will be the overall impact on the positions.
The point to note here is — irrespective of where the price is headed whether it increases or decreases the position will neither make money nor lose money.
It is as if the overall position is frozen. As I had mentioned earlier, hedging single stock positions is very straight forward with no complications. But to use the stocks futures position one must have the same number of shares as that of the lot size. This leads to a few important questions —. In fact the answer to both these questions is not really straight forward.
We will understand how and why shortly. For now we will proceed to understand how we can hedge multiple spot positions usually a portfolio. I guess we are at a good stage to introduce beta, as it also finds its application in hedging portfolio of stocks.
In plain words Beta measures the sensitivity of the stock price with respect to the changes in the market, which means it helps us answer these kinds of questions —.
The beta of a stock can take any value greater or lower than zero. Here is a step by step method to calculate the same; I have taken the example of TCS. You can refer to this excel sheet for the above calculation. Let us now focus back to hedging a portfolio of stocks by employing Nifty futures. However before we proceed with this, you may have this question — why should we use Nifty Futures to hedge a portfolio?
Why not something else? Do recall there are 2 types of risk — systematic and unsystematic risk. When we have a diversified portfolio we are naturally minimizing the unsystematic risk. What is left after this is the systematic risk. As we know systematic risk is the risk associated with the markets, hence the best way to insulate against market risk is by employing an index which represents the market. Hence the Nifty futures come as a natural choice to hedge the systematic risk.
There are a few steps involved in hedging a stock portfolio. The sum of the weighted beta is the overall Portfolio Beta. For the portfolio above the beta happens to be 1. Likewise if Nifty goes down, the portfolio is expected to go down by 1. Remember this is a long only portfolio, where we have purchased these stocks in the spot market.
We know in order to hedge we need to take a counter position in the futures markets.