Chapter 14: How to Use Futures for Hedging?
What comes to your mind when you hear the word Hedging? If, “protection against any type of risk” is your answer, then your on track and this is exactly what we shall be discussing in this chapter.
Whether we like it or not , we all are prone to some kind of risks around us.
Our day-to-day business activities like buying and selling of goods and services or assets and commodities inherently has market risk involved, as price movements can be random due to demand and supply factors.
So how does businesses ensure that they remain profitable inspite of these fluctuations leading to price risks?
Most businesses try and mitigate their price risk by Hedging using derivatives.
As seen in the example in chapter 1 , Mr Nivesh the Bakery owner used derivatives to hedge his price risk for his raw material supply so that he is able to maintain the bottom line of his business.
Similarly, Mr Kisaan also used derivatives to get fair value of his produce ahead of time that too before even harvesting his crops. Thus creating a win win for both parties – the buyer and the seller.
In today’s world, hedging is almost a part of managing business activities by most of the major corporations and business houses.
In fact, with the development of futures market across the world , even small businesses have also started using futures to hedge their losses against adverse price movements impacting their profitability.
Hedging in the Futures Market
Futures market is one of the most rewarding markets for traders or investors as they enjoy the benefit of financial leverage, ulltimately helping them generate higher ROIs.
But what most traders or investors tend to ignore is the risk associated to using leverage in futures trading. Well the risk of leverage is real and its inevitable to completely avoid it.
However, risk can be managed through Hedging. Lets understand How can we use hedging as a tool to manage risk in futures trading with an example. This example is based on how to hedge your portfolio against adverse price movements.
With constant news around of having a global recession, he’s worried that his portfolio will go in the red. Now Mr Chintamani has 3 choices.
Both are logical solutions to his problem but has their own consequences. If Mr Chintamani opts for the 1st choice, it may take years for the markets to recover and the drawdown on his investments may push him towards panic selling and ultimately may have to face losses.
If he opts for choice no 2 and what if the market scenario changes overnight? Recession fear vanishes and global markets witness a Bull Run.
Mr Chintamani, who was waiting for this bull run for years now, witnesses the opportunity of a lifetime just pass by right in front of eyes.
FOMO (Fear Of Missing Out) is bound to hit him hard, and mind you, there is nothing more dangerous than investing out of FOMO.
The thought of FOMO puts Mr Chintamani to do some research and find out a way wherein he can continue to hold his portfolio and find a hassle-free way to stay invested and to avoid any opportunity loss, due to non-participation in the markets.
And that’s when he discovers the concept of hedging with futures trading which gave him a 3rd choice.
During his research, he noticed that he had the option to remain invested and didn’t have to worry about the fall in his portfolio. Sounds amazing isn’t it?
Mr Chintamani was blown away by the fact that he could protect his overall investments by hedging and immediately started to dig deeper into the possibilities.
The question now comes to mind is How can “going short” on Stocks or Nifty 50 be a hedge against the portfolio of Mr Chintamani?
The answer is simple, assuming that the economy is headed for recession is true, naturally, all the people who own stocks will start selling their existing holdings in anticipation that they shall repurchase them later when the dust settles.
Instead of selling the stocks that Mr Chintamani owns in his cash market portfolio, he can sell futures of the underlying cash market stocks that he owns.
Since we know the fact that, if the underlying stock prices decreases, its future contract value will also decrease and so Mr Chintamani will hedge his portfolio by selling stock futures.
Now, what if Mr Chintamani holds stocks which are not traded in the futures market?
He still has an option of selling the Nifty50 Futures which is a leading index that comprises of top 50 stocks by market capitalisation across all the sectors. Naturally, if a recession hits hard, indeed it will affect all the companies across all the sectors and hence the index will also fall.
Mr Chintamani can hedge by going short on Nifty50 Futures and even though his cash market portfolio is falling , he will benefit from the short Nifty position creating a hedge against the fall in value of his portfolio.
Hedging With Futures: How to Create a Hedge Against a Portfolio
With the example of Chintamani, we learnt hedging with futures is possible both in individual stock futures or hedge against the overall portfolio. However, there’s one limitation which arises due to the standardisation futures markets traded on stock exchanges.
Remember we have discussed that in the F&O markets, futures contract are traded in fixed lot sizes. Hence, the concept of a perfect hedge is a little difficult to find.
Let’s assume that Mr Chintamani owns a diversified portfolio of 10 stocks and the total portfolio value is INR 10 lakhs.
To create a hedge for his portfolio against selling Index futures, Mr Chintamani needs to figure out the following factors which can help him create a full or partial hedge.
- Correlation of stocks with respect to the portfolio
- What is the beta of the portfolio versus the index
We’ll help you understand both.
If the prices of one asset moves in the same direction as the other asset , they are said to have a positive correlation.
If the prices of both the assets move in the opposite direction , the correlation is negative.
So correlation will help Mr Chintamani choose the right asset for hedging.
But finding out the correlation isnt just isnt enough for Mr Chintamani to derive a full or partial hedge against the portfolio.
Correlation will help him, filter the asset needed to choose for hedging in case of cash stocks to stock futures.
But to find out how a full or partial hedge between cash stocks and index futures , another variable know as beta has to be considered.
Beta will help Mr Chintamani identify how much the overall portfolio might decrease compared to the decrease in the index.
- Beta = 1: Fall is almost equal in stock portfolio and index.
- Beta < 1: Stock portfolio will decrease lesser than the index.
- Beta > 1: Stock portfolio will decrease more than the index.
Mr Chintamani can either apply these mathermatical model to calculate a perfect hedge ratio which is required or he can use this hack.
Let’s say the beta of his cash portfolio is almost equal to 1. With a basic observation, Mr Chintamani arrives at an approximation that if the markets declines about 1% his portfolio value also declines by 1%.
Based on the beta, if Nifty 50 falls by 1%, Mr Chintamani’s portfolio will also fall by 1%.
Lets compare the profit and loss of the above trade and see how this trade will act as an hedge for Mr Chintamani.
As you can see that with the hedge trade taken Mr Chintamani has made a 1% gain against the loss on the overall cash portfolio creating a good hedge for himself with the down move.
However, the hedge is not perfect and thats because of the fact that futures are traded in fixed lot sizes but more or less his portfolio is almost saved from the damage.
Hedging in futures market is a tool used by traders for risk management. Some of the most successful and profitable traders have some kind of a risk management system in place and this is exactly what we shall be discussing in the next chapter.