What is Hedging?

A hedge is an investment done with the goal of reducing the risk of adverse price movements in an asset. A hedge is an investment in a security that correlates well with the asset to be hedged.

How does Hedging work?

Hedging is an effective tool that provides protection against downside risk in times of uncertainty. The most common hedge is the famous 60/40 stock and bond portfolio held by retirement savers. Every kind of diversification is a hedge in a way. That is why a portfolio of 10-20 stocks is considered a safer investment than just investing in two stocks like Reliance and Bharti Airtel.

Examples of Hedging:

1. Hedging a single stock position using Futures: Let us assume that you are long 300 stocks of SBIN at Rs. 420. This is a total investment of Rs. 1,26,000. Now you are uncertain about the SBIN stocks near future. So, you decide to hedge this exposure using the futures market. The lot size is 300 and the futures price is Rs. 421. Since you are long the stocks, you decide to short the futures market by selling 1 lot of futures. This will be an amount worth Rs. 1,26,300. Now the additional 300 will be extra as one can never achieve a perfect hedge. If the price falls, one can book the profit in futures sell and hold on to stock if the long term view is bullish. But when the stock goes up, then there wonít be any profit as hedge will be incurring loss. Mutual Funds do hedging against the stock holdings using shorts in futures, but they do in a proportion so there is profit on upside movement in the stock.

2. Commodity Futures: Companies in the airline industry are dependent on the prices of fuel. When the price of oil goes up, one of the input costs for the airline company goes up. That reduces the stock price. So, an investor holding airline stocks can hedge his exposure by buying oil futures. When the price of oil goes up, the airline stock declines but at the same time oil futures would have appreciated. This how the oil hedge works perfectly for an airline stock.

3. Diversification: Diversification is the most famous form of hedging non-systematic risk. If we buy a number of stocks for our portfolio, then the concentration risk is reduced. Let us say that we hold technology and banking stocks in our portfolio, then if the technology stocks decline then the banking stocks can act as a hedge. One need to follow a capital allocation policy which ensures no concentration on a single stock or sector.

4. Stock Portfolio hedge with Index Options/Futures: Let us first learn about the two types of risks Ė systematic and non-systematic risks. When we diversify a portfolio of stocks, we are reducing the non-systematic risk. To reduce the macro/market risk i.e. the systematic risk, we need to make use of an index option that rather replicates the market movements. Letís take that one has invested in stocks with portfolio value of closer to 8L. Nifty lot (size 50) at current price (16,500) will be closer to the portfolio value. If there is an upcoming event like Union Budget or Union Elections or US Presidential election results that can move the market big, one can hedge the portfolio by simply buying a Nifty at the money put option for that month. In case of fall in market, put will give profits. Sometimes, traders just short Nifty Futures as well. One point to consider is that portfolio should move in sync with Nifty for the hedge to be effective.

Benefits of Hedging

1. A hedge can protect your capital in the case of a black swan event. A black swan event is something that occurs rarely but has the potential to cause massive destruction of wealth in the financial markets. A hedge can simply keep you in the business when things go from bad to catastrophic. In March 2020, almost all asset classes dipped as investors faced a liquidity crunch.

2. Traders and investors with a low tolerance for risk can use a hedge to preserve not only capital but also achieve peace of mind. By putting on a hedge, traders and investors can make consistent gains while also have peace of mind by knowing that they are not taking too much risk.

Drawbacks of Hedging

1. Hedging provides muted returns as it eats away from your return stream. A hedge is useful only if you expect a sudden spike in volatility. If you expect the returns to go up higher, then a hedge will only be a drag on your portfolio performance.

2. Hedging involves buying a financial asset to offset the risk of another. The purchase of financial assets come with transaction costs. If the trade for the hedge is not well planned and executed, it can end up eating away your returns by incurring transaction costs.