Understand How Future and Options Can Be Used for Hedging

Understand How Future and Options Can Be Used for Hedging

Hedging is about protection of your risk; which can be downside risk or upside risk. Hedging may not eliminate risk, but it reduces risk in exchange for a small cost. Today, in India, futures and options trading is a key tool for hedging your stock market positions and reducing the risk. You can effectively use futures and options to manage your risk either at a stock level or at an index level.

One of the best ways to get a equity hedge on your stock holdings is through the use of put options. That is extremely popular as is using stock futures to hedge positions. Here we look at the use of futures and options. Of course, stock hedging is only possible in the case of F&O stocks where F&O trading is allowed.

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How to use stock futures and index futures to hedge risk?

The accent is on hedging with stock futures or alternatively with index futures. This entails a cost in terms of margin money. However, in the event of a downside stock futures and index futures can also provide protection. Here is how it works and we can look at 3 different situations.

a) The simplest way to hedge risk is by selling stock futures to protect from the risk of stock prices going down. This is also called locking in profits or locking in loss as the case may be. Assume that you bought a stock at Rs450. Since you are a long term investor you don’t bother about a stop loss. However, the price has come down to Rs430 and the news flows are not too encouraging. You can sell the stock futures at a price of Rs430 and lock in a maximum loss of Rs20. It does not matter how low the stock price goes; your loss can never go above Rs20. You can also look at stock futures to book profits.

b) Can you protect against volatility using futures. Remember, in any bout of volatility, the risk is mostly on the downside only. So, the prices of the stock are more likely to fall than they are likely to rise. All you need to do is to repeat the previous situation and sell futures. But the question is what stock futures to sell? Obviously, when the market is volatile, all stocks are going to get hit, not just one or two stocks. You cannot be selling futures on all your stock positions and some may not be there on F&O. In that case you can use index futures and use beta hedging to decide how much of index futures to sell. This is not a perfect protection, but it is good enough.

c) The third use of futures is to protect profits. This is a rather unique kind of hedging where because here you are using hedging with stock futures to protect your profit not to protect against loss. Let us assume that a week after you bought a banking stock at Rs.1,250, the government announced a major bank recapitalization program. Over the next 3 days, the stock went up to Rs.1,580. Should you book profits or use stock futures? One option is to sell the stock futures at Rs1,580 and lock in profits of Rs330. That is locked in even if the stock price comes down. If the price goes further up, you can keep a stop loss on the futures position and close out the futures and hold the cash positions.  
Normally, hedging using stock futures works best for individual stocks since beta hedging is not a perfect approach. However, if you are looking at portfolios, hedging with index futures using beta hedging better. Don’t forget that you can also protect profits with hedging.

Using options to hedge your stock price risk

In the previous header, we saw about how to use futures to hedge risk. Here we look at how to use options to hedge risk. There are different ways to approach the problem. Simple rule is that you have a stock position, then just buy a lower strike put option. Your loss gets limited. Let us consider an illustration to understand how this works. You are very positive on XYZ Ltd but you also believe that the global rate hikes could spoil the party. Even as you hold on to your stock position you simultaneously use options to reduce your risk. Here is how it works. Take the case of XYZ Ltd – Bought at Rs.318 | 310 put option bought at Rs.4 | Creation of a hedge

What this put option based hedging assures you is that under no circumstance will the loss on your position be more than Rs.12 (318 – 310 - 4). Due to hedging your maximum loss has been clearly defined and therefore you can work accordingly, knowing that come what may your total loss on the hedged position will not exceed Rs.12. On the upside, breakeven level (no profit no loss) is Rs.322, as that covers the purchase price in cash market plus option premium of Rs4.

A slightly different method of using options to reduce cost of holdings

If you are not comfortable with an aggressive approach to hedging, you can use call options to reduce your cost of hedging. Let us rephrase the above case as under:

• Buy XYZ Ltd at Rs.318
• Buy XYZ Ltd 310 put option at Rs.4
• Sell XYZ Ltd 335 call option at Rs.2

What is the big advantage of adding one more level to this hedging strategy? As a result, your net cost of hedging has come down to Rs.2 and your monthly cost of hedging reduces from 1.3% to 0.65% and looks a lot more palatable from a cost of funds point of view. This strategy works very well when you believe that XYZ is likely to be range-bound in its price movement. Selling the higher calls definitely impose an outer limit on your profits but will also simultaneously reduce your cost of hedging. However, this does entail a higher transaction cost and higher margin requirement. Alternatively, you can just sell higher calls against cash market holdings to reduce your cost of holding when stock price is down. However, be careful not to close the cash market position alone.

The takeaway is that even options can be effectively used to reduce the risk of your equity market positions.