After a market correction, most of us are haunted by the "If only I had booked my profits!" syndrome, thanks to the benefit of hindsight. But, then, is it not always easier said than done? For instance, take the case of Mr Gupta, a medium/long-term investor. His portfolio value had soared each day with the market touching new highs, but after a week of market correction, these notional profits in no time became notional losses. If only he had booked his profits!
Identifying market crests and troughs is next to impossible. But premature profit-booking can make an investor as miserable as a delayed one. So what can investors with a sound portfolio do at such times? If your portfolio consists of stocks with good future prospects, exiting them is probably not the right solution. At such times, hedging comes to the rescue. Hedging, in general, can be defined as an investment made to reduce the risk of adverse price movements in a security, by taking an offsetting position in a related security. These can take the form of an option or a short sale. However, remember that hedging is not a way to increase your profits, it is just an effective way to reduce losses.
Who needs to hedge?
Investors who are uncomfortable with market volatility or those with financial goals that involve selling shares in the future (which would be affected severely if the market drops) are the ones who need to consider hedging. Or any investor who wants to lock into a particular sale price for stocks, despite a crash in the market, can also consider hedging.
Consider this: Say, you hold 1,000 shares of XYZ Company. While being bullish on the long-term prospects of the company, you are also worried about the short-term blips that your stock might face due to market volatility. To protect yourself from any short-term downside risk, you can buy a put option on the stock, which gives you the right to sell that share at a specified price. So, even when your stock price falls below the current (strike) price, the loss would be offset by the gains in the futures market. But this strategy works well with only those stocks that are traded in the derivatives segment of the exchanges. Then, how do you hedge stocks that do not have any derivative counterpart? For such stocks, you can consider buying a put option on the index. This would help you neutralise the impact of the market (index) movement on your stock, leaving you with a position that depends purely on the performance of the XYZ share. In other words, you have now effectively reduced the influence of market movements on your stock.
But if you have a portfolio of several stocks, it may not be feasible to take offsetting positions for each. So, you can consider hedging the entire portfolio. Going short on Nifty futures or buying index puts would help.
Assume that your portfolio value is about Rs 10 lakh. You sell a Nifty futures contract at 3,900. So, if the Nifty future falls to 3,750, you will make profit from the futures contract.
The profit will be 3,900 minus 3,750 (multiplied by the number of contracts you bought). This would help contain the losses that your portfolio will incur due to the fall in prices of stocks.
An alternative strategy can be to buy Nifty put options. Say, you buy a Nifty put option at a strike price of 3,800, trading at Rs 50, when the index is at about 3,950.
So, if Nifty falls to 3,750, your put option would trade at a price higher than the purchase cost. The profit, thus made, would help you contain the notional loss of your portfolio.
Buying Nifty puts, unlike the Nifty futures, requires no exposure and are limited loss instruments that can be more useful provided the time value of money is acting in your favour. In other words, the value of your option might diminish as it nears the expiry date. Futures can be quite risky if not monitored regularly and, at times, can result in huge losses.
Risk-return trade-off
However, to effectively hedge yourself , you need to know the extent to which your portfolio moves in tandem with the market (its correlation with the index). You can use beta values (available in the NSE monthly newsletters) of the stocks against the index for arriving at that.
`Beta' captures the extent to which the value of your portfolio mirrors every movement in the index; higher the Beta, higher the correlation with the index.
This would help you estimate the number of contracts you need to buy/sell so as to completely hedge your portfolio.
You can either partially or fully hedge your portfolio depending on your risk appetite; but remember lowering of risk also reduces your return prospects. Nevertheless, even a reasonable estimation of beta value would help deliver a satisfactory hedge.
But in case you are wondering about what happens to the hedged positions if markets do not correct as expected, the answer is simple.
Those positions would expire with time and the money that you had invested in creating the hedge would be offset by the increase in value of the stock prices. After all, is that not why we all invest?
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