Hedging: Meaning, Types of Strategies, and Risk

March 10, 2020April 18, 2021 admin

Hedging is an important tool that investors can employ to diversify risk

Hedging basically means minimizing or controlling the risk involved during a transaction. In other words, it is an investment position intended to offset the potential losses which may be incurred by a companion investment.

Insurance can be the best example of hedging. When we buy a flat that costs lakhs of rupees, we usually buy home insurance along with it by paying a small premium.

So that if something untoward were to happen and the house gets damaged in an earthquake, fire, flood, etc all is not lost. The insurance will reimburse the losses, the amount in accordance with the risk cover taken.

A hedge does not prevent any worst thing from happening, but it surely helps in minimizing the financial loss arising out of any unwanted event. In common parlance, there is a saying “Zor Ka Jatka, Dheere Se Lage”

Similarly, hedging is like insurance that protects you against loss of money in the stock market. The word “hedge” means a boundary, fence, or barrier and it works exactly in the same way. In other words, if you have a farm where you grow your crops and if you don’t fence it properly to protect the crops then it may cause damage by stray animals. The same applies to stocks.

You would purchase a stock if your bullish with the hope that you will make a profit if the stock goes up. But at the same time, you are at risk of making a loss from that position if the price falls.

To prevent such kinds of losses you can use different types of hedging strategies and instruments that can help you to save or minimize losses in case your buy decision backfires. And hedging can be one important strategy to prevent such kind of losses.

Difference between Hedging and Arbitrage

This is the common mistake most people do interchanging the terms hedging and arbitrage. In fact, both are totally different from each other, a different concept altogether.

While we have already discussed hedging above but arbitrage is the practice of taking advantage of the price difference between two markets so as to make a profit. Earlier investors used to buy in BSE and sell in NSE to earn the price difference, but now this is totally stopped.

For example, investors used to buy a stock at Rs 100.50 in one exchange say BSE and simultaneously selling the stock for 101 in NSE. This way investors used to make risk free profit of 0.50 paise, and it is called arbitrage.

But in the case of hedging, it is usually done to reduce the risk not to earn profit whereas arbitrage is done only to generate profits.

Correlation

Usually, to make a hedge, there should be a correlation between the two entities involved. In the case of finance, a statistical measure of how two securities move in relation to each other is known as correlation.

A perfect positive correlation ( a correlation coefficient of +1) implies that if one security moves up or down, the other security will also move in the same direction ( if BPCL goes up then HPCL stock will also go up)

Alternatively, in case of perfect negative correlation ( a correlation coefficient of -1) means that if one security moves in a positive direction the other security will move in completely opposite in negative direction ( if the Stock of ICICI Bank goes up then the Sun Pharma Stocks will go down)

If the correlation is 0, then the movements of the securities are said to have no correlation, they are completely random.

Hedging Instruments

For trading in the equity market, Futures and Options are the best hedging tools. Let’s not discuss in detail what Futures and Options are and their working.

Hedging with Futures

Long Stock, Short Index Futures/Stock Futures

If you have bought stocks of a company with the intention that the stock price will go up, the stock faces two kinds of risks

Your reading may be wrong while picking up the stocks, the stock may already be overpriced and it may start to fall

Your reading about picking up the stock may be right but the entire market may fall or crash and consequently, your stock price may also fall.

To hedge the risk, you should take an opposing position by selling the particular Stock Futures (future contract of particular stock) or index futures ( futures contract of the entire market index)

So if your stock were to fall or the market were to fall, your position in the stock will be making a loss, but on the other side, your short position in the stock/index will rise and thus your overall loss may be hedged or even you may end up gaining a certain amount of profit.

2.Short Stocks, Long Index Futures/Stock Futures

Consequently, if you have a short position in a stock that is possible only on an intraday basis, you can buy Index/ Stock Futures for hedging

Therefore, if the stock price starts to rise or the markets on the whole start to rise, then the loss on your short position will be minimal due to hedge by the rise in the long Index/Stock Futures

Hedging with Options

Long Stock, Buy Index Put Options/Buy Stock Put Options

If you have invested in the stock for the long term, you can hedge your stock position by buying Put Index Options or Put Stock Options just by paying a small premium.

You can create a hedge by taking a long position in the stock by buying a Put Option so that if the stock price falls the Put premium goes up, covering your losses from the stock fall.

Similarly, if you have a short position in a stock (only for intraday trading), then you can hedge it by buying Call Index or Call Stock Option. So if your short position in the stock goes up, then the loss can be minimized or reduced in the call price.

A few more Hedging Instruments

Diversification

This is the best and simple method of doing hedging in your equity stock portfolio. You can just diversify your portfolio or can spread your investment into various stock categories like Large-cap, Midcap, Smallcap, high beta, low beta, defensive and aggressive.

This diversification of your portfolio can reduce the risk in the adverse movement of any particular category and protect your portfolio from losses.

Pair Trading

When two highly positively correlated stocks from the same industry sector are used for hedging wherein the investor goes long in one stock and short position on the other is known as Pair Trading.

For example: if you go long in ICICI Bank and make a short position in Axis Bank is known as pair trading.

Although it becomes a zero-sum game, the strategy can be tweaked according to one’s perception of the movement of the market. For example, If you feel that the market will go up then you can buy large quantities of ICICI Bank and short less quantity of Axis Bank.

Debt

The term debt can be defined as Fixed deposits, bonds, liquid funds, and debt funds. Debts and equities are negatively correlated.

Though this will not form a perfect hedge but adding them to your portfolio can give you a decent hedge against a fall in the equity component in your portfolio, this debt instrument gives positive returns although they are low.

Gold

Equity and Gold are generally negatively correlated. So if you have a stock portfolio then invest some amount in gold for hedging. Therefore, if your equity starts to fall for any reason the Gold component of your portfolio will keep it up and reduce the risk by hedging.

Real Estate

The real estate investment requires a large amount of funds but after the 2008 market crash when the equity market was down the real estate investment has given manifold returns. Hence, real estate can be considered a perfect hedging tool against stocks.

The Idle Hedge Ratio

When a percentage of the total value of the equity portfolio protected via hedge as compared to the entire position. This ratio is known as the hedge ratio.

For example: If you have a position in stock worth 10 Lakhs and you have sold stock futures worth 5 lakhs. Then the hedge ratio would be 5/10=0.5 or 50% of your portfolio is protected against a downside risk via hedge.

Different Types of Hedging Strategies

Perfect Hedge

Any counter position that completely eliminates the market risk element of an existing position is known as a perfect hedge.

Cross Hedge

When a hedge is done by taking an opposite position in an entity that is different from the initial entity. But which is positively correlated with that entity is the cross hedge.

For example: If a company stock ICICI Bank moves exactly in line with the movement of another company Axis Bank. Then one can buy ICICI Bank in the cash market and sell Axis Bank in the Future. This position is known as a cross hedge.

Double Hedge

When hedging is done by using both Futures and Options thereby doubling the size of the hedge is commonly known as a double hedge.

Partial Hedge

When some part of the entire portfolio is hedged is known as a partial hedge.

Full Hedge

If you take an exactly opposite position to protect 100% of your portfolio investment is known as a full hedge.

Rolling Hedge

The Rolling Hedge is done to close existing F&O positions as they near maturities and initiating fresh positions next future maturity.

Rio Hedge

The Rio Hedge is used when investors face a liquidity crisis or capital constrain. This hedge is used in a slightly lighter vein. This means a trader initiated a huge investment and to hedge his position buys a ticket to some tropical destination Rio. So that if the investment backfires the trader can fly to this destination to escape from financial and legal repercussions.

Things to Keep in Mind

Investors/traders should remember that hedging does not completely eliminate the risk
Hedge positions will always make less profit than unhedged ones.
At the time of hedging costs such as brokerage, taxes and other charges should be factored in.
Derivative instruments used for hedging will require margin and M2M funds
Chances of both positions taken incurring losses cannot be ruled out.
The tax treatment of profit and loss for the different instruments is entirely different.
The different types of Hedging strategies mentioned above are not advised for small investors since the extra cost does not leave much on the table. It is suitable for investments of substantial amounts.
Hedging is used to reduce risk. But it also means reduced profits.