We’ll start with hedging a single stock future because it’s the most straightforward and straightforward to accomplish. We’ll also learn about its limitations before moving on to how to hedge a stock portfolio.
Assume you purchased 250 shares of Infosys for Rs.2,284 each. This equates to a Rs.571,000/- investment. In the spot market, you are clearly ‘Long’ on Infosys. You realize the quarterly results are due soon after you start this role. You’re concerned that Infosys will release less-than-optimal financial results, causing the stock price to plummet. You decide to hedge the position to avoid a loss in the spot market.
We merely need to enter a counter position in the futures market to hedge the spot position. We must’short’ in the futures market because our spot position is ‘long.’
Now, on the one hand, you are long Infosys (in the spot market), while we are short Infosys (in the futures market), though at different prices. However, the price fluctuation is unimportant because we are ‘neutral’ in terms of direction. You’ll see what I’m talking about in a minute.
Let’s assume several price points for Infosys after we’ve started this trade and see what the overall impact would be on the positions.
The important thing to remember is that regardless of where the price is headed (up or down), the position will not make or lose money. It’s as if the entire situation has remained static. Indeed, the position becomes agnostic to the market, which is why we say that a hedged position remains ‘neutral’ to the overall market environment. Hedging single stock positions, as I previously stated, is quite simple and straightforward. To hedge the position, we can use the stock’s futures contract. However, in order to trade stocks futures, one must have the same number of shares as the lot size. If they change, the profit and loss statement will change, and the position will no longer be perfectly hedged. This raises a few crucial questions
- What if I hold a position in a stock that isn’t traded on a futures exchange? Does this indicate that I can’t hedge a spot position in South Indian Bank because it doesn’t have a futures contract?
- In the example, the spot position value was Rs.570,000/-, but what if I only had a few tiny holdings, say Rs.50,000/- or Rs.100,000/-? Can I hedge such situations?
In truth, neither of these questions has a straightforward answer. We’ll find out how and why in due time. For the time being, we’ll focus on learning how to hedge numerous spot holdings (usually a portfolio). To do so, we must first comprehend what is referred to as a stock’s “Beta.”
Can we use options to hedge futures?
Please keep in mind that hedging futures risk using options is contingent on market conditions, your risk tolerance, and the size of your investment.
That means that instead of purchasing or selling naked options, you should use option techniques to hedge futures risk.
FinIdeas offers a course called Smart Futures’ Trader. This course covers the following key topics for hedging futures risk with options.
- When it comes to futures trading, how and when might we get stuck? (Think about it, but don’t take it for granted.)
- Synthetic Derivatives Formula (Most Important topic for fund management & RiskManagement)
This is an online course, so you may learn whenever and wherever you want. All of this may be learned in 8 to 10 hours.
Remember that hedging isn’t just for risk management; it’s also for money management. Good luck with your trading!!!
In Nifty options, how do you hedge?
Assume you own 1,000 shares of ABC at a price of Rs 1,000 per share. The stock price rises to Rs 1,200 after two months.
You are concerned that the price would drop to approximately Rs 1100 next month, but you do not want to sell your investment because you expect large profits in the long run. Buy 5 Put Options with a lot size of 200 shares each to hedge your present equities holdings. You pay a Rs 5 premium each share.
Now, as the price falls, the value of your Option rises, and vice versa.
The stock price dropped to Rs 1150 next month, just as you predicted. The premium has increased to Rs 15.
Because you are not selling your equity holdings, this is merely a theoretical loss. As a result, anytime the stock price returns to Rs 1200, You’ll end up with a net profit of Rs 10,000.
Is it possible to hedge with options?
Hedging is a risk-mitigation method in which investors take another investment position to decrease or eliminate the risk of owning one.
Option contracts are an excellent way to protect yourself from underlying stock risks. Investors will obtain the knowledge they need to begin using options as a hedging strategy in their own portfolios after reading this article.
Hedging is a method of preventing a loss in an investor’s portfolio. Hedging, on the other hand, results in reduced returns for investors. As a result, hedging should not be utilized to create money, but rather to safeguard against losing money.
The two investments must have a negative correlation in order for hedging to succeed. As a result, if one investment loses value, the other must gain value. This is when choices come into play.
Assume an investor purchases 100 shares of XYZ stock for $100. The investor is bullish on the stock, but he is also concerned that it will fall in the near future. To protect against a possible stock decline, the investor purchases a $1 per share put option. The put option has a strike price of $90 and will expire in three months. This option allows the owner to sell XYZ shares for $90 at any moment during the next three months.
Assume XYZ is trading at $110 in three months. The put option held by the investor will not be exercised. The increase in stock price from $100 to $110 will net him $10. He does, however, lose the $1 per share premium he paid for the put option. As a result, he will make a total profit of $9 per share.
Assume that in three months, XYZ will be trading at $50. If this occurs, the investor can exercise his put option and sell XYZ shares for $90 instead of $50. He loses $11 per share by doing so. Let’s take a look at another example: hedging with a call option. Assume that an investor is shorting 100 shares of XYZ, which are now trading at $100 per share. An investor anticipates a decline in the stock’s price, but he wants to hedge against a possible increase in the near future. The investor purchases a $2 per share call option to protect against a probable price increase. The call option has a strike price of $98 and will expire in a month. This option allows the investor to purchase XYZ shares for $98 at any time within the next month. more than $51 a share The put option protects the investor from suffering a significant loss.
Let’s take a look at another example: hedging with a call option. Assume that an investor is shorting 100 shares of XYZ, which are now trading at $100 per share. An investor anticipates a decline in the stock’s price, but he wants to hedge against a possible increase in the near future. The investor purchases a $2 per share call option to protect against a probable price increase. The call option has a strike price of $98 and will expire in a month. This option allows the investor to purchase XYZ shares for $98 at any time within the next month.
Assume that XYZ is trading at $90 in a month. The call option held by the investor will not be exercised. Short selling the stocks from $100 to $90 will net him a profit of $10. He does, however, lose the $2 per share premium he paid for the call option. As a result, he will make a total profit of $8 per share.
Assume that XYZ is trading at $120 in a month’s time. If this happens, the investor will use his call option to make a profit. As the stock rises from $100 to $120, the investor will lose $20 a share from the short position. However, by executing the call option, the investor will be able to purchase XYZ for $98 and subsequently sell it for $120 at the market price. The investor earns $22 per share from the call option. But don’t forget about the premium paid for the call option, which cost $2 per share. As a result, hedging allows the investor to break even (22 20 2 = 0).
Following these two examples, investors should see the importance of hedging in their own investment portfolio. When an investor is unsure about the future movement of a stock’s price, put options and call options are both excellent tools for limiting or eliminating loss.
What’s the best way to hedge your options position?
First, assess the trend strength of the underlying security as well as market conditions in general. Determine how much of the position you want to hedge based on your risk tolerance. For example, if you paid $500 for an XYZ call option and anticipate the stock would climb, you may feel comfortable hedging 25% of your position cost. Multiply the option cost by the position percentage you want to hedge to get the amount you need to hedge. For example, multiplying the $500 option cost by 25% equals $125, which is the amount you want to hedge.
How do futures contracts protect you against risk?
Hedging is the practice of buying or selling futures contracts to safeguard against the risk of losing money due to fluctuating cash market prices. If you’re feeding hogs to market, you’ll want to hedge against dropping cash market prices. If you need to buy feed grain, you’ll want to hedge against rising cash market prices.
In India, how do you hedge options?
Hedging methods, which employ derivatives to protect the downside of an existing portfolio, may not be thrilling in a range-bound market like the one we’re in now, but they can be effective in runaway markets (recall the surge in January-February 2012). Any time following a high surge in the markets, as a stock investor, it may be a good opportunity to utilize a hedging technique to protect your winnings against a sudden sharp market correction. Angel Broking Ltd’s head of derivatives, Siddharth Bhamre, says: “Hedging isn’t very popular because individuals don’t consider the possibility of a decline while the markets are surging, and then panic when the markets are drastically down. When there is too much positive, a hedge is the greatest option.” In the other situation, when markets are down and trading lower, there is no need to hedge; you may simply buy shares.
Kotak Securities Ltd’s associate vice-president (derivatives), Sahaj Agrawal, explains “Consider it in the same way as you would life insurance. This means you pay a fee to safeguard something, and if something bad happens, you reap the benefits. If, on the other hand, things continue to go well, you’ll have to forego the cost of no return.” This means that in order to protect the value of your portfolio, you will have to pay a fee, which is the option premium. Your portfolio value is safeguarded to the extent that your hedge protects it if markets decline. If they don’t, you’ll only lose the premium. The cost of this premium is often between 1% and 3% of the portfolio’s value (for the option discussed in this article). If the markets are volatile, this premium will climb.
Warnings: Hedging is only for the brave and experienced stock investor. If you’re a seasoned equities investor with high discipline and a sizable cash reserve, you should consider moving into derivatives. Stick to simpler investment vehicles like mutual funds and a conservative asset allocation to hedge your risks if you’ve just been investing for two or three years. According to Pawan Joseph, vice-president of Motilal Oswal Wealth Management, “We urge clients to avoid using derivatives in favor of long-term investments. The purpose is to provide customers with products that are in line with their asset allocation goals.”
Here are two hedging tactics you can implement to protect your direct equities account.
Purchase a put option that is “at the money”: A put option allows the buyer to sell the underlying security (in this case Nifty) at a predetermined strike price. The option you must purchase is a one-month put option at the money.
The term “at-the-money” refers to an option’s strike price being the same as the underlying security’s current price. This means that a Nifty put option will have a strike value of 5,200 today, and the cost to buy one will be roughly Rs.
How can you protect yourself against lengthy positions?
Simply expressed, hedging is the process of safeguarding yourself in the event of an unexpected event. In the context of concentrated stock investments, there are several types of hedging to consider, many of which can help you protect yourself in the near term against the danger of a significant price decrease. Options can help you control that risk in a variety of ways, but they aren’t suitable for all investors.
Buy a Protective Put Option
By doing so, you effectively put a floor on the value of your shares by granting you the right to sell them at a set price. Purchasing put options that can be exercised at a price lower than the current market value of your shares will assist limit potential losses on the underlying equities while still allowing you to benefit from any prospective increase. However, if the stock’s price remains above the put’s strike price, you lose money on the option.
Sell Covered Calls
Selling covered calls with a strike price higher than the market price can assist mitigate potential losses if the stock’s price falls. The call, on the other hand, limits how much you may profit from any price increases. And, if the stock price reaches the strike price of the call, you’ll have to be ready to take the call.
Consider a Collar
This hedging strategy entails purchasing protective puts and selling call options with premiums that cover the cost of the puts. The upside gain for your investment is therefore limited to the strike price of the call, just like with a covered call. If that price is achieved before the collar’s expiration date, you could lose not just the premium you paid for the put, but you could also be subject to capital gains tax on any shares you sell. You must exercise caution while shutting one side of the collar while the other half of the transaction is still open. You could end up with an uncovered call if you exercised the put but the shares you sold were later called away before the call’s expiration date. If you have to repurchase the shares at a higher price to fulfill the call, you could lose money.
Furthermore, the pricing set for a collar must not be in violation of the regulations prohibiting a “constructive sale.” A risk-free plan is effectively a sale, and hence subject to capital gains taxes. Collar strike prices should not be too close to the current market price of your stock.
Option trading entails risk and is not appropriate for all investors. In a relatively short period of time, it is possible to lose the entire sum paid for the option. A copy of “Characteristics and Risks of Standardized Options” must be obtained before buying or selling an option. This material can be obtained through your financial advisor or downloaded from the Options Clearing Corporation’s website.
Monetize the Position
You might be able to monetize your position through a prepaid variable forward (PVF) arrangement if you need immediate funding. With a PVF, you agree to sell your shares at a minimum price at a later date. When the agreement is completed, you receive the majority of the money for those sharestypically 80 percent to 90 percent of their value. Until the PVF’s maturity date, which could be years away, you’re not required to turn over the shares or pay taxes on the sale. When that date arrives, you must either pay the agreed-upon amount in cash or give over the proper number of shares, which will change depending on the stock’s current price. In the interim, your stock is kept as collateral, and you can utilize the advance payment to diversify your portfolio by purchasing additional assets. A PVF also allows you to benefit from price appreciation throughout that time, albeit there may be a limit on how much you can gain.
PVF agreements are difficult, and the IRS advises that they should only be used with caution. Before deciding on a PVF, it’s a good idea to talk to a tax specialist.
Exchange Your Shares
If you wish to diversify your portfolio, an exchange fund, a private investment entity that offers tax-free diversification to investors with highly appreciated low basis stock, may be a good option. You essentially exchange your shares for units in a diversified fund that provides wide equity market exposure, lowering your risk while avoiding the immediate tax ramifications of a sale. Because the fund typically pays no or little interest, the requirement for income is an issue to consider. Because you must stay in the fund for seven years to fully benefit from the tax-free exchange, this technique is best for long-term wealth transfer planning.
Donate Shares to a Charitable Trust
If you want to focus on income rather than growth, you might want to consider putting your stock in a trust. Consider donating a highly appreciated stock to a charitable remainder trust if you have one (CRT). When you make a donation to a CRT, you will obtain a tax deduction, and the trust will be able to sell the shares without incurring capital gains taxes, allowing it to reinvest the proceeds to produce an income stream for you, the donor. The remaining assets of the trust are retained by the charity when the trust is terminated. You can choose a payout rate of 5% or higher that matches both your financial and philanthropic giving objectives. Please keep in mind that the donation is final.
A charity lead trust (CLT), which is similar to the CRTs mentioned above in many aspects, is another trust gift alternative. A CLT, on the other hand, gives the income stream to your selected charity organization for a set period of time, with the remainder going to your beneficiaries.
Creating and maintaining trusts comes with a price tag. You won’t get a tax break for moving assets to a CLT unless you name yourself as the trust’s owner, in which case you’ll have to pay taxes on the annual income.
Another altruistic option is to make a tax-deductible donation to a charity or private foundation.
In India, how do you hedge a portfolio with options?
We all know that having options is a privilege that comes with no obligation. However, the main goal isn’t to take a speculative position on stocks and indices. The true goal of options is to assist you in better mitigating and managing your risk. Options give you the flexibility to accurately define your position’s risk and to calculate your risk in various circumstances. As a result, understanding how to use options to implement hedging strategies is critical. Let’s look at how to risk hedge with options, as well as some examples of hedging with options.
Assume you are extremely bullish on SBI, but you also feel that if the Federal Reserve announces a negative interest rate, SBI’s shares will suffer. Even as you hold on to your stock investment, you employ options to mitigate your risk.
SBI Bought at Rs.318 | SBI 310 put option purchased at Rs.4 | SBISBI PriceOption price hedge
Mark to market (SBI)
MTM3350.25+17-3.753251.25+7-2.753057.25-13+3.2529519.25-23+15.25 SBI Put MTM3350.25+17-3.753251.25+7-2.753057.25-13+3.2529519.25-23+15.25 SBI Put MTM3350.25+
In the example above, SBI’s equity market position was hedged by purchasing a cheaper put option. This put option guarantees that the maximum loss on your position will never be more than Rs. 12 (318 310 + 4). Your maximum loss has been clearly established as a result of hedging, and you may work appropriately, knowing that no matter what happens, your total loss on the hedged position will not exceed Rs.12. Because your notional losses will be offset by profits on the call option if the price of SBI falls below Rs.310. On the plus side, SBI’s breakeven point is Rs.322. At that time, you’ve covered the cost of the put option, and your earnings can continue to grow indefinitely.
This is a more practical concern. There will be months when the SBI price will rise and months when the SBI price will fall. How do you make the hedge function effectively for you? There are two ways to accomplish this.
To begin, you can simply hold your put option each month until it expires. In most cases, hedging your put options will cost you around 1.30 percent per month, or around 15.6 percent annually. To only cover the cost of hedging, you’ll need to make at least 15.6 percent on your SBI cash position each year. That is obviously a significant expense, and there is no guarantee that SBI will provide you with anything more. That brings us to the second hedging strategy.
Second, you can choose a somewhat more aggressive hedging strategy. You can book profits on the put option and cash the earnings if the price of SBI falls throughout any month and the put option becomes valued beyond a certain point. The only thing you need to remember is to replace the position as soon as possible with a new put option in the following month’s contract. Assume that SBI has 8 up months and 4 down months in a year. You profit during the down months, and you just let the put option expire worthless during the up months. As a result, your hedging cost may not be zero at the end of the year, but it will be far lower than the 15.6 percent hedging cost you would have paid initially. This aggressive method lowers your hedging costs, and all you have to do is remember to replenish the hedge.
If you don’t want to take an aggressive approach to hedging, you might use call options to lower your hedging costs. Let us restate the preceding scenario as follows:
The benefit in this case is that your net hedging cost is reduced to Rs.2, and your monthly hedging cost is reduced from 1.3 percent to 0.65 percent. This greatly improves the appearance of your hedge. When we believe SBI is likely to be range-bound, this method works quite well. Selling the higher calls may limit your earnings, but it will undoubtedly lower your hedging costs. This has a greater transaction cost and margin need, but it is appropriate for people who are not comfortable with an aggressive approach to portfolio risk hedging.
Options can clearly be employed smartly and efficiently to lessen the risk of your equity stock market trading positions. It’s actually incredibly easy to do and very effective!
What is the best way to hedge a call and put option?
A put option can be used to lock in a profit on a call without having to sell or execute the call immediately away. When the shares of XYZ sell for $50 each, the XYZ call buyer might buy a one-month, $50 strike put. It’s possible that the put will set you back $100. Among the possible results are:
- The buyer makes a $250 profit if nothing else changes until expiration ($500 intrinsic value at expiration $150 call premium $100 put premium).
- If the stock falls below $50, the call’s loss is offset by the put’s gain.
- If the stock rises to $55, the buyer will profit $750 at expiration ($1,000 intrinsic value of call $150 call premium $100 put premium).
