Understand How Future and Options Can Be Used for Hedging

Understand How Future and Options Can Be Used for Hedging

Hedging with futures and options helps reduce risk—both downside and upside—though it may not eliminate it entirely. In India, futures and options trading is widely used to manage stock market risk at both the stock and index levels. One of the most effective strategies is using put options to hedge your equity holdings. Another popular method is using stock futures to protect your positions. However, such hedging with futures and options is only possible in F&O-listed stocks. While there's a cost involved, the reduced risk makes it a valuable strategy for investors.

You may also want to know about Is Trading In F&O A Good Decision?

Table of Contents

1. Understand How Future and Options Can Be Used for Hedging
2. How to use stock futures and index futures to hedge risk?
3. Using options to hedge your stock price risk

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

Hedging with futures and options is a key risk management approach in Indian markets, especially when using stock or index futures. While it involves costs like margin requirements, it provides effective downside protection. Here’s a quick guide to three key hedging strategies in derivatives using futures:

1. Hedging Losses with Stock Futures

One common strategy is selling stock futures when a stock starts to fall. Suppose you bought a stock at ₹450, and it drops to ₹430 amid negative news. By selling stock futures at ₹430, you lock in a maximum loss of ₹20—regardless of further price drops. This is a practical options hedging example, though it uses futures, and is ideal for locking in losses or profits.

2. Volatility Protection via Index Futures

When markets turn volatile, it’s tough to hedge every stock, especially those outside F&O. Instead, you can use index futures for broader portfolio protection. Through beta hedging, you estimate how much index futures to sell based on your portfolio’s sensitivity to the index. While not perfect, it's an effective method of hedging in uncertain markets.

3. Protecting Profits Using Futures

This unique strategy uses stock futures to lock in gains. For example, if you bought a banking stock at ₹1,250 and it surged to ₹1,580 after a major announcement, selling futures at ₹1,580 secures your ₹330 profit—even if the stock later falls. If the stock keeps rising, you can place a stop-loss on the futures and retain your cash position. 

4. Futures vs Options for Hedging

While futures are ideal for direct hedging and profit locking, options offer more flexibility. A classic protective put strategy involves buying a put option to cap potential losses while retaining upside potential—often preferred by long-term investors.

For more practical tips, explore the Blinkx F&O trading guide to understand how to apply these strategies effectively. Whether you're hedging losses, managing volatility, or locking in profits, hedging with futures and options offers robust tools to safeguard your investments.

Using options to hedge your stock price risk

In the earlier section, we discussed how to hedge risk using futures. Now, let’s explore how hedging with futures and options also includes using options strategies—especially puts—to manage downside risk effectively.

A simple and popular protective put strategy involves holding a stock and buying a lower strike put option. This limits your losses while keeping the upside open.

Example: Hedging Stock with Put Option

Let’s say you’re bullish on XYZ Ltd, bought at ₹318, but concerned about global interest rate hikes. You can hedge this risk by buying a 310 strike put option at ₹4. This setup limits your maximum downside while allowing you to stay invested.

This is one of the most straightforward options hedging examples, allowing you to manage risk efficiently without selling the stock.

Futures vs Options for Hedging

While futures lock in both gains and losses, options offer flexibility—you only pay a premium, and losses are capped. That makes options ideal for long-term investors who want protection without exiting positions.

To dive deeper into such hedging strategies in derivatives, the Blinkx F&O trading guide offers practical tools and insights for effective risk management using both futures and options.

Whether you are managing volatility or protecting profits, hedging with futures and options gives you multiple ways to stay ahead in the market.
 

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

An effective way to enhance your protective put strategy is by adding one more layer—selling a higher strike call option. This converts your position into a collar strategy, which significantly reduces the cost of hedging.

For example, if your initial put cost is ₹4, selling a call for ₹2 brings your net hedge cost down to ₹2. This cuts your monthly hedging expense from 1.3% to 0.65%, making it far more cost-effective. This approach is ideal when you expect the stock (like XYZ Ltd) to remain range-bound.

While this strategy limits your upside potential, it’s a trade-off for lower costs. Keep in mind, though, that it may involve higher transaction fees and margin requirements. Alternatively, you can sell higher calls against your cash holdings to reduce holding costs—but ensure you don't exit the cash position alone.

This is a strong options hedging example, showing how even options alone can reduce equity risk. Compared to futures, this strategy offers more flexibility, supporting the case in the futures vs options for hedging debate.

For detailed insights and execution tips, refer to the BlinkX F&O trading guide. Whether using basic puts or advanced combinations, hedging with futures and options provides robust hedging strategies in derivatives to protect your market positions.