The name of the game..Hedge..Hedging

Another important terminology in trading is Hedging. So why not let’s learn something about Hedging.

Hedging

A strategy designed to reduce investment risk using call options, put options short selling or future contracts. A hedge can help to lock the profits. Its purpose is to reduce the volatility of a portfolio by reducing the risk of loss. But before knowing more about Hedging lets know some terminology which is related to hedging.

Call option: This is an option contract that gives its holder the right to purchase a specified number of shares of the underlying stock at the given strike place on or before the expiration date of the contract.

Put option: This is an option contract that gives the holder the right to sell a certain quantity of an underlying security to the writer of the option at a specified price up to a specified date (i.e. expiration date).

What actually does hedging mean?

Hedging refers to a portfolio management technique that helps to reduce risk. Suppose a mutual fund has invested in stocks, and the fund manager expects the market to go down in the near-term. If the market does indeed fall, the net asset value (NAV) of the fund will also decline. The fund manager can minimize the loss by "hedging" his portfolio in anticipation of the fall. Now the question is how does he do hedging?

Since he holds stocks, he will invest in derivatives in such a way that the contracts benefit from the fall in index value. This is possible by selling derivative contracts.

Portfolio managers prefer futures to options to hedge their market risk. Why?

If we buy futures, we have to pay a margin, which is adjusted daily for the gains/losses that we make on our futures position. So, therefore, we do not incur any cost for buying futures. This is quite unlike options, where we have to pay a premium to buy calls and puts. This premium is a cost to the call/put buyer.

Hedging is a two-step process. A gain or loss in the cash position due to changes in price levels will be countered by changes in the value of a futures position. For instance, a wheat farmer can sell wheat futures to protect the value of his crop prior to harvest. If there is a fall in price, the loss in the cash market position will be countered by a gain in futures position.

There are two types of Hedging. Buy or Long Hedging and Sell or Short hedging

Buy or Long Hedge: A buying hedge is also called a long hedge. Buying hedge means buying a futures contract to hedge a cash position. Dealers, consumers, fabricators, etc, who have taken or intend to take an exposure in the physical market and want to lock- in prices, use the buying hedge strategy.

Benefits of buying hedge strategy:

• To replace inventory at a lower prevailing cost.
• To protect uncovered forward sale of finished products.

Selling or Short Hedge:

A selling hedge is also called a short hedge. Selling hedge means selling futures.

Benefits of selling hedge strategy.

• To cover the price of finished products.
• To protect inventory not covered by forward sales.
• To cover the prices of estimated production of finished products.

Now, consider a fund that has portfolio worth Rs 100 crore. Suppose the fund manager sells Nifty futures contract at 1070. If the Nifty future falls to 1044, the fund will generate profits from the futures contract.

The profit will be 1070 minus 1044 times the number of futures contracts. This profit will help reduce the losses that the fund will incur because of the fall in price of stocks in its portfolio.

The most important step in portfolio hedging is the hedge ratio. This ratio tells the fund manager how many contracts to buy to minimize the portfolio risk.