To hedge a position in cash (participating F&O stocks) & futures market, use options (Buy Put for Long Futures & Bought Stocks, Call for Short future).
Let’s talk about ‘Hedging’ today. Financial dictionary adaptation of Hedge is ‘an investment to reduce the risk of adverse price movements in an asset’.
In simple words, additional positions that create compensatory positive cash flows when the original position starts bleeding.
Simple example is life insurance, a hedge against death. But more than what is a hedge, the most important thing to understand is ‘How to & When to Hedge’.
But before we do that, let us understand two minor but crucial details of Hedge.
1. A Hedge always comes at a cost which is irrecoverable
2. A hedge can prevent future damage but cannot undo past damage
Now once that is clear, let us understand when to hedge? There are three scenarios where hedging becomes crucial, which has to do with dealing with past, present and future risks.
Past:
Let us say one already has a position in the equity market (cash, futures or options). The position starts incurring losses. Now many of us (including me at times) would not be willing to exit at our pre-defined level.
When it comes to taking that bit of extra more risk beyond calculation, create a hedge.
Result: The position won’t bleed any further and we would still be in the around, just in case the position turns favourable after hitting the stop loss.
Present:
This one is my favorite. This compensatory trade would occur when we are sitting on profits right now. In that case, instead of mulling over whether or not to book take a cost to create an opposite position in option and sit on it keeping the upside open at the same time locking accrued profits.
Future:
Now here, why not many of us resort to hedging is because of the very first characteristic, it comes at an irrecoverable cost. Even so, have a big heart and create a trade with a hedge alongside to safeguard the future. The benefit is very simple our maximum loss is defined hence, just track profits, do not track losses.
Now comes the answer to the question - How to Hedge?
To hedge a position in cash (participating F&O stocks) & futures market, use options (Buy Put for Long Futures & Bought Stocks, Call for Short future) most of the times the cost of hedging wouldn’t go beyond 3-4% even if the hedge is kept for a good 20+ sessions. I have always found prudence in choosing the strike close the current market price.
Now for the stocks not participating in F&O, if one is trying to hedge a bunch of stocks against market falling then the following equation viz. Contract value (Lot Size * Strike Price)of Index Put Options Bought = 2-3 X Portfolio Value, has made sense for me a few times.
However, many times behaviour of a peculiar portfolio could be very different, hence try resizing and exiting, keeping this hedging as last resort.
Last but not the least, if it is about short options to be hedged, take a compensatory trade in higher call or lower put (OTMs) depending upon the position. In case of an entrapment into options that have gone in the money, I would rather buy multiple of OTMs so that adverse move can be reasonably compensated.
While if one is trapped in the Long Option position, restrict selling options 1:1 unless otherwise it’s the week of expiry and one can keep a close track of it.
MORE WILL UPDATE SOON!!
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