What is Hedging in the Share Market and How Does it Work?

Key Takeaways

• Hedging is a strategy to reduce risk by taking a counter position using derivative instruments like futures and options.

• Traders widely use hedging strategies to protect profits from adverse price movements during volatile and bearish markets.

• Hedging can also help to get the margin benefits by taking a counter position in option buying.

Introduction to Hedging

In the world of the share market, risk is unavoidable. Share prices fluctuate due to demand and supply dynamics, economic factors, company financials, global events, and investor sentiments. This uncertainty in the stock market makes risk management crucial for investors.

Hedging in the share market is a technique to minimise the risk in investments and protect investors from heavy losses. Just like insurance protects your car or health, hedging protects your portfolio from adverse price movements.

For traders dealing with volatile indices like Nifty 50 and Sensex, hedging becomes important to manage sudden price movements.

What is Hedging?

In financial markets, hedging refers to a technique of taking a position in a market that offsets potential losses in another investment. Hedging allows the trader to minimise the risk by taking an opposite or counter position. However, it also reduces the overall returns from the investment.

In simple terms, hedging is about reducing risk, rather than maximising profits.

Example:

Suppose you own shares of company X, and due to a bearish market phase, you expect prices to fall. To prevent your portfolio from loss, you decide to buy a Put option of Company X.

Now, if the share price of X falls in the cash segment, you incur a notional loss. Meanwhile, in a put option, the premium will rise, and you make a profit.

Therefore, you incur a loss in the cash segment but earn a profit in the put option, which offsets the overall portfolio losses.

How Hedging Works in the Share Market?

Hedging works on a simple principle of taking an opposite position to balance the risk.

When you hold a stock in your portfolio, the share price continues to fluctuate up and down during the live market.

In a bullish market phase, your portfolio often performs well and share prices move upwards. However, during the bearish market phase, the share prices witness selling pressure and slowly begin to fall.

If you want to protect your portfolio from the short-term downside risk due to a bearish market phase, hedging strategies work well.

During a market correction, you can use derivatives such as futures or options to create a counter position and hedge the risk.

If the market falls, your counter position in derivatives gains value and offsets the losses. This makes hedging an essential tool for risk management during volatile periods.

Types of Hedging in the Share Market

Hedging can be done through derivative instruments like futures and options or through diversification across sectors and asset classes.

Hedging Using Options

In the share market, options are one of the most popular instruments for hedging. Investors use call options and put options to hedge the downside risk and limit the losses.

• A put option gives you the right to sell a stock or asset at a fixed price before or on a predetermined expiration date. In the context of hedging, put options help to protect the portfolio gains against the portfolio losses.

• A call option gives you the risk to buy a stock or asset at a fixed price before or on a predetermined expiration date. Traders use a call option in the sideways market phase to generate regular income from premium decay.

However, when you hold a short position in stock or index futures, buying a call option can hedge the risk and limit the losses.

Similarly, when you sell a call option or a put option, your risk is unlimited. In such a scenario, buying a call or put helps to limit the risk and also provides margin benefits.

Hedging Using Futures

Hedging through futures is another powerful tool used by traders. When you expect a fall in the market and portfolio stocks, you can build a short position in the index futures or stock futures to offset the losses.

Hedging Through Diversification

Hedging through diversification across sectors and assets is a simple and effective method. In the stock market, not all sectors perform at the same time. Big players keep shifting money from one sector to another for various reasons.

Portfolio diversification across sectors and asset classes helps to reduce dependence on one sector or asset class.

Suppose you own a portfolio of stocks, a mix of banking, IT, capital goods and pharmaceuticals.

Due to geopolitical issues, the banking and IT sector stocks are witnessing a correction. Meanwhile, capital goods and the pharma sector performed well and offset the losses.

Similarly, portfolio diversification can be achieved across different asset classes as per the risk appetite.

Investors seeking diversification across asset classes invest in a mix of equities, debt, commodities, ETFs, and mutual funds.

Why do Investors Need Hedging?

Hedging can be a useful tool for traders and investors due to the following reasons:

• Protection against market volatility:

There are times when the market becomes highly volatile. Hedging helps to minimise the risk during a high volatility period and provides peace of mind to continue investing.

• Diversification:

A diversified portfolio can also be impacted during a recession. Hedging across sectors and asset classes can help to reduce the broader market risk and bring stability to the portfolio.

• Minimise the risk of loss in a bearish market:

Hedging the stocks with instruments like options can help to minimise the risk in a falling market.

• Safeguard the expected returns:

Hedging helps to safeguard the profits from the investment, which have already been appreciated.

• Protection against currency risk:

For portfolios with international exposure, hedging can help in managing currency risk and interest rate fluctuations.

Advantages of Hedging in the Share Market

There are many advantages of hedging in the share market. Here are a few of them:

• Portfolio Stability:

Hedging provides stability in the portfolio by ensuring the value of assets remains stable during volatile or bearish phases.

• Flexibility:

Hedging allows investors to take advantage of flexibility. Investors can use various hedging strategies to reduce the risk in uncertain market movements.

• Margin Benefits:

Futures trading and option selling need high margin requirements. Hedging helps traders to get margin benefits by opening a counter trade in option buying.

Risks Involved in Hedging

Hedging involves certain risks which can impact portfolio returns. Before hedging, it is important to know the risks:

• Cost:

Hedging often increases the trading cost. Taking counter trade involves costs like brokerage, STT and other taxes. Investors need to carefully analyse the cost and try to find the break-even point for the calculation of net returns.

• Overhedging:

Overhedging occurs when an investor tries to hedge every market scenario. It can lead to a reduction in profitability and overall returns.

• Counterparty Risk:

Hedging involves entering into contracts with counterparties. If the counterparty fails or defaults on its obligation, the hedge holder can face huge losses.