Using futures to hedge a portfolio when markets are volatile

Hedging is a technique that ensures that the value of a stock or a portfolio held by an investor remains more or less constant. While it does not allow the investor to gain from an up side in the market, it ensures that he will not have to bear the brunt of a downfall…

While the markets are rising at a dizzy pace, there’s immense scope for making money. However, if you are not prudent, there’s plenty of scope for losing money too. Fortunately, there are portfolio management techniques, involving futures, which can be used to ensure that the value of your equity holdings is not eroded. This technique is known as hedging.

What is hedging?

To put simply, hedging means managing a portfolio in a manner in which it is at least partially protected from market risks. In effect, it helps you to limit the downside of the value of your investments. From the retail investor’s perspective, hedging becomes most relevant while investing in assets like equities, commodities etc., where there is a possibility of a depreciation in the value of the portfolio or there are chances of erosion of the principal itself.

Derivative instruments like futures and options are widely used for the purpose of hedging. Different investment techniques must be employed while using different instruments and here we will only take a look at how futures can be used for hedging.

What are futures?

Futures are derivatives contracts in which the underlying index or an asset (stock, commodity, etc.) is bought or sold for a specific price on a specific date in the future. To buy or sell a future, you must pay margin money, which is a percentage of the total contract value.

For a better understanding, let us look at an example – Rajesh Kumar is bullish about the prospects of the stock market and feels that the Nifty would put on gains in the next thirty days. So he buys Nifty Futures which are trading at Rs 5,805, while the underlying S&P CNX Nifty index is quoting 5770. The lot size for this contract is 50. The contract value, therefore, would be Rs 2,90,250 (Rs 5805 50). Rajesh can buy a Nifty future contract by paying a 15 per cent margin amount of the contract value, which would work out to Rs 43,537. Now if the Nifty future rises, Rajesh will stand to gain from it. At any given point of time he could sell off his contract and book profits. However, he would incur a loss if the Nifty future declines below his purchase price. He will be refunded the margin amount that he has paid earlier when he opts to square off the transaction.

Had Rajesh been bearish about the market outlook, then he could even take a short position by selling a Nifty futures contract. Like index futures, stock futures contracts could also be entered into where you take a call on the direction of an individual stock movement.

Hedging with futures

Now let’s see how Rajesh can use futures to hedge his portfolio of stocks. Let’s suppose he holds a well diversified portfolio of stocks, the value of which moves in line with the Nifty. In order to ensure that the value of his holdings is not influenced by a sudden downward movement in the index, he can short sell Nifty futures to the extent of the value of his portfolio. Here’s how the value of his portfolio remains protected:

         If the markets are falling, the value of his portfolio of stocks will fall. However, he will make gains on the short sold Nifty. More specifically, at any point of time, if he disinvests his whole portfolio, the loss he makes will be more or less compensated for by the gain he makes from first selling the Nifty futures and then buying them back at a lower price.

         If the markets are rising, unfortunately, although the value of his portfolio results in a gain, the Nifty futures will deliver a loss that will more or less neutralize the gain made on the portfolio appreciation.

Such hedging can also be carried out on specific stocks. A common practice in the market is buying a stock in the spot market and selling futures on the same stock. This will ensure that the depreciation in the value of the stock is neutralized by the short selling gains made on the stock future.    

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