Trading Hedging Strategy in Options - Meaning & Examples

Isha: Do you use an umbrella when it rains?

Shiva:Yes!

Isha: Take car insurance before driving your new car?

Shiva:Yes, of course!

Isha: Do you have a screen guard on your phone?

Shiva:Is that even a question? My phone is my life! Absolutely!

Isha: Then why don't you hedge your positions in the market?

Shiva: Hedge? What is hedging? What is hedging in trading?

Hedge meaning

A hedge refers to a way of protecting oneself against adverse circumstances. In other words, shielding oneself against loss by taking balancing or compensatory actions. A hedge is basically an insurance. The term hedging is mainly used in the field of horticulture and finance though both have very different meanings.

What is hedging in the stock market?

Hedging meaning in stock market: Hedging in the stock market refers to safeguarding one position in the market by taking another opposite position. This is done to reduce the risk of uncertainty or loss that may occur due to unfavourable price fluctuations.

Let us understand this with the help of an example. Mr. Arshdeep has taken a long position in Tata Motors and according to his analysis it will be profitable to have the share as a long-term holding. But his analysis also suggests that the price of Tata Motors might fall this month. So decides to hedge by short selling it in futures while keeping his equity position intact. 

Mr. Arshdeep safeguards his long position in Tata Motors by taking another position (short selling Tata Motors Futures) with the aim of reducing the risk of uncertainty or loss that might occur due to fall in price of the stock in the short term.

Types of hedging strategies in the Equity Market

• Using Futures

As seen in the example, Futures can be used to hedge positions in the cash market. The frequently used futures hedging strategies include:

1. Hedging a position in the cash market with its Futures contracts.
2. Hedging a position in the cash market with Nifty Futures contracts.
3. Hedging an entire portfolio with Nifty Futures contracts.

• Using Options

Options can also be used to hedge positions in the equity market with the help of hedging strategies like:

• Covered call
• Covered put
• Protective call
• Protective put and many more.
• Asset allocation   

Now for those investors that don't trade in derivatives, they too can hedge by simply investing across asset classes like fixed deposits, gold, Provident funds and other debt instruments. Asset allocation strategy aims to reduce risk by diversifying the investor's portfolio. So the investor doesn't have all eggs in one basket.  

Pros of Hedging

Following are the pros of hedging:

• Protects the investor against the downside: If a trade doesn't go as expected, instead of experiencing heavy losses, the trader can cut his losses. Hedging helps to mitigate losses to a significant extent depending on the strength of the hedge.
• Promotes liquidity: Hedging promotes liquidity because it allows investors to invest in different asset classes.
• Derivatives act as hedging instruments for long term investors: Futures and options are perfectly equipped for short-term risk-minimising strategy not only from traders but also for long-term traders and investors. In fact options strategies like Covered Call allow investors and traders to maximise returns even when markets are range bound.  
• Protection against risk from external factors: Hedging provides the trader protection against external factors such as currency exchange rate changes, interest rate changes, inflation, etc.
• Saves time: Hedging can also save an investor a lot of time as he doesn't have to constantly monitor his portfolio.

Cons of Hedging

Following are the cons of hedging:

• Cost involved: Hedging involves a cost that tends to bite into the profit, if the original trade goes right.
• Risk reward ratio: Risk and reward are usually proportional to one other; thus, reducing risk will lead to reduced profits.
• Complex for short term traders: For most short term traders like day traders, hedging can be a complex strategy to follow.
• Capital Requirement: Trading in options or futures often requires high capital investment, it can be used elsewhere.

Need for Hedging

Following are the reasons why hedging is needed:

• For risk averse investors: Hedging allows risk averse investors to take large positions in the market as it minimises the level of risk.
• Hedge against volatility: Hedging provides traders and investors peace of mind in volatile times by safeguarding them against any big unfavourable swings in the markets. 
• Saves time: Hedging helps an investor save time as he doesn't have to constantly monitor his portfolio and can use it more effectively elsewhere.

So we can conclude that hedging strategies help investors to sleep peacefully at night instead of waking them up with nightmares of 'what if?'.