Called hedging, strategies that use derivatives to protect the downside of an existing portfolio may not be very exciting in a range-bound market, which is the case currently, but in on-sided markets, such products may be useful. Anytime, as a stock investor, after you experience a sharp rally in the markets, may be a good time to use a hedging strategy against the risk of a sudden sharp market correction, keeping the profits intact. On the other hand, when there is negativity in the markets and they are trading lower, there is no need to hedge, you can simply buy equity.
If markets fall, your portfolio value is protected to the extent of your hedge. But if they don’t, all you lose is the premium. The cost of this premium is usually between 1% and 3% (for the option mentioned in this article) of the value of the portfolio. This premium will rise if the markets are volatile.
Caveats: Hedging is meant only for the experienced equity investor. If you are an experienced equity investor with good discipline and sufficient surplus, then move towards derivatives. If you have built a portfolio in just the last two-three years, stick to simpler investment instruments such as mutual funds and stay with a disciplined asset allocation to hedge your risks.
Buy an “at-the-money” put option: A put option gives the buyer the choice to sell the underlying security (in this case Nifty) at a pre-determined price known as the strike price. The option you need to buy is at the money one-month put option.
The term “at-the-money” means that the options’ strike price is the same as the current price of the underlying security. Today, this means a Nifty put option will have a strike value of 7,900 and the cost to buy this is currently around Rs.120. Keep in mind that while hedging, it is important to choose the security that has high volumes, so stick to the nearest one-month option. If you are starting a hedge now, you will be buying the September 7,900 put option. The number of options you buy will depend on your portfolio value.
Here is how it works: Let’s say you have a large-cap-oriented equity portfolio worth Rs.10 lakh, then you have to buy Nifty put options equal to the current market value of this portfolio. If the market moves above the strike price or the current value (since they are the same) you will not exercise the option and things remain as they are. Your portfolio value will increase with the market. If the market falls below the strike price, then the loss on your portfolio is compensated by the gains you make on the option. Your put option says you have the right to buy Nifty at 7,900, so the profit you make if, say, Nifty drops to 7,400 is simply 7,900 minus7,400, or Rs.400.
Short futures: For this hedge, you need to short-sell or sell shares first and buy them back later. In the practical transaction, you don’t actually buy back the shares or the index, rather just settle the difference. For example, if you short-sell Nifty futures at 7,200 and the market falls to 7,400, you gain because you have already sold Nifty at 7,900 and you can buy it at 7,400. Your gain is Rs.400 and the transaction gets closed when that amount is credited to your trading account. Similarly, if Nifty moves to 8,300, you lose Rs.400 and the transaction is closed by debiting your trading account with that amount, but the value of your existing portfolio rises.
Here is how it works: If you have a portfolio consisting of large-cap shares you can short- sell Nifty futures for a value equal to the value of your current portfolio. Unlike an option trade, this is a hedge where you lock in the upside. In other words, you simply protect the value of your portfolio from declining further, but don’t stand to gain anything.
This is what it means: If you are hedging your portfolio, you expect the market to correct a bit and that’s why you want to protect your profit. If the market moves up, the short position you have taken in the futures runs into a loss. You will see a negative payoff on that trade but keep in mind that your original equity portfolio will gain roughly an equal amount, thanks to the upmove and the loss on futures will cancel out the gains in the equity portfolio. The opposite happens if the market corrects; you lose on your equity portfolio and gain on the futures, thereby netting out the overall payoff. So this strategy helps you protect your current portfolio value as it is, but there are no gains. If the market has moved up and you incur a loss on the futures trade, in the event that you don’t make good the loss from your gain on the other portfolio, the 25% margin with the broker will be used against the loss settlement.