HEDGING WITH DERIVATIVES – AN ADVACED STOCK INVESTMENT STRATEGY

This article is of little use to those investors who are expert derivative traders and know, how to use hedging for their portfolio against market risk. But, of utmost know to factor to the investors, who are away from the derivative segment and are likely to know about. Let’s read.

What is Hedging And Who Is A Hedger

A strategic trading strategy in the derivative market, to protect the value of equity portfolio against price fluctuations is called hedging. When there is an uncertainty in the price movement of any stock, stock investors can hedge the price of a stock from a fall, by participating in the derivatives market. And, such investor is then called to be a Hedger.

Hedging is nothing, but securing the price of a stock by speculating market movement. In other words, it’s an advanced equity investment strategy, where the equity investments are protected in the market fall /fall in the price of a stock scenario. Hedging gives a sort of ‘peace of mind’ to the equity investors, by ensuring a more predictable outcome.

Hedging of a Stock doesn’t give more outcome, but it definitely gives a more predictable outcome.

What Are The Types Of The Risks Associated With Any Stock

While buying a stock every investor thinks and hopes that, it will move forward and there will be a hike in the stock price. But, nobody can make sure that the price hike is definite. There are certain risk factors, that may restrict the stock price, and push it down.

The stock price is always a function of many risk factors, which will decide its future. Some are specific to the particular stock and sector. And some are global. Market risk is considered as an external risk factor that will equally affect the entire industry. For example, currently the Diamond Industry, is facing such a type of Market Risk. Which is unavoidable by all the stocks of various companies that belong to this industry.

How To Hedge A Stock

Hedging is an art of ensuring the return of an equity investment apart from market risk. This is done by participating in the derivatives market, and execute exactly the opposite trade. That means, the trade which  opposite to the trade in equity segment. By doing so, one can ensure the return from either the equity /derivative market, as the two segments move in opposite directions. In this form, one can bypass the risk to those who are willing to bear it.

There are two types of derivative contracts, that help the investors to hedge their investments in the cash segment, that is equity. They are Futures and Options.

For example Mr. A holds 100 shares of a company XYZ. If the buy price is Rs. 10 per share, and the stock price is hovering around Rs 10 and Rs.12, for a month. Then Mr. A speculated the price movement towards negative direction. And, he decided to liquidate his holding predicting its future fall. But, his advisor and friend, Mr. B suggested him to hedge his holding  to ensure his future earnings at the cost of the premium to be paid to buy a contract in the derivatives segment. So, Mr. A postponed the idea of selling the shares at the current market price. And, decided to sell the stock at the expected Rs. 15 after 3 months.

Even though there are many contracts to hedge the stock value in derivative segment, the best one is the PUT Option, which he can utilize to sell his stock after 3 months and at the strike price.

Put Option gives the buyer to sell the stock  during a predetermined period and at the predetermined strike price, which is usually above the market price.

The cost of buying a Put Option increases with strike price. That means, higher the strike price, the higher the cost. So, it is always advisable to choose the strike price moderately to hedge the stock.  So, Mr. A chose to buy the 1 ATM Put of 100 shares with the 3 month expiration period.  He paid Rs. 100 towards premium and his strike price was Rs.11

As per his expectation the price of his stock fell to Rs.10. And, Mr.A exercised his option to Put his quantity of 100 shares at Rs. 11 each. The amount he received was Rs. 1100. So, the loss is only the amount that was paid towards commission while buying the stock. In India the Futures and Options, of all the listed stocks expire on the last Thursday of the contract month. If that Thursday is declared to be the holiday, the expiry day will be the preceding Wednesday.

If you like my article, leave your comment. I value your comments, and try to rectify my defaults.

Happy Investing!

 

 

Hameeda Ghori

Certified Financial Planner And Stock Analyst

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