How can you Hedge your Positions in Futures and Options

Posted by Kalpesh on November 2nd, 2022

To Hedge means protecting yourself from market uncertainties or risk; limiting the risk on your portfolio. Hedging includes the buying of an asset and also simultaneously selling the asset. It will offset the associated risk. Hedging plays an important role in adverse market situations and can help you avoid significant financial losses. You can say it is similar to buying insurance for your car. As you can save huge accidental expenses by paying a small amount every year as a premium, in the same way, you can save big losses by entering into F&O.

Future and options contracts are among the best methods used over many years for hedging and saving your portfolio against market turbulence.

Before we move to understand which option hedging strategies in India are the best for hedging, there are certain things you need to take care of, and they are as follows:

• While hedging your position using options, make sure your strike price is slightly out of the money.
• Please stay away from deep out-of-the-money; they might expire worthlessly.
• If you are using the put options for hedging, then check the price; they might be overpriced or underpriced. You may use the  Black-Scholes calculator available on every Option trading platform. Avoid buying overpriced options.
• Try to exit the market when the stock moves beyond the 85% limit. After that limit, new options and futures get banned.
•  Keep a close eye on the transaction cost. You have to pay the costs such as Brokerage, GST, STT, Turnover tax, stamp duty, etc. the cost of transactions on different Option trading platform would be different, so choose your platform keeping in mind the cost.
• Make use of Options algo trading India softwares to get an accurate and in-depth market scenario.

Hedging with options:

Suppose you are long on Stock A, whose spot price is Rs. 100, and you have 15,000 shares. This amount totals your portfolio of Rs. 15,00,000.

Now, due to any market turbulence, such as economic instability or political pressure, etc., Stock A fears a price fall. In such a situation, you can do three things;

1. Allow the market to fall and do nothing. Hope that it shall recover soon
2. Calculate your profit and loss and exit the position or
3. Hedge your portfolio.

Now, if you decide to hedge your portfolio, you can buy the put options by paying Rs. 5 per share as a premium. These 5 Rs. is the amount you can bear if the market is not in your favor. If the market is not in your favor, you lose 75,000 (15000*5), and you can make unlimited money if it is in your favor.

The above example can have three different scenarios: if the price increases, decreases, or stays stagnant. Let us see their impact on our portfolio.

Case 1: if the price increases to Rs. 120 from 100

Here a trader has made a profit of Rs. 20. By paying Rs. 5 as a premium

to enter into the contract. Thus the net profit is Rs. 15 (20-5).

Case 2: if the price decreases to Rs. 80 from 100

Here we have a loss of Rs. 20 in the cash market and can make Rs. 15 as a profit in the derivative market; however, we have also made a loss of Rs. 5, paid as a premium initially.

Case 3: if the price remains 100, it does not change.

In this case, a trader will have no gain or loss in the cash market. However, a trader lost Rs. 5 paid as the premium.

Hedging with futures:

Futures are a type of contract allowing the contract holder to buy or sell the underlying asset at a future date. The contracts are obligatory, and contract holders must execute them. They are not like options where there is no obligation. Traders use future contracts to avoid the loss due to volatile markets. Investors or traders take a long position when they are sure to buy or sell the asset in the long run, and by entering into a future contract, they lock the price. Now no movements can affect the price of the underlying asset.

Suppose you buy 300 stocks of company Z at Rs. 2350/share. It totals Rs. 7,05,000. Now because of some reason, you predict the price falls, so you hedge your position in the futures market to avoid the loss.

It can be as follow:

• The strike price of the futures contract is Rs. 2355
• The lot size of the stock to enter into futures is 250 shares per lot
• Thus the value of this contract would be Rs. 5,88,750.

By covering one position with its opposite position, you are boosting the immunity of your capital and indifferent to the market price change. Traders may also use the multiple legs, but we hope you are clear on how futures can be helpful to hedge your portfolio and help you reduce the risk.

To know more about how you can hedge your positions using futures and options contracts, call us at the number provided on your screen.