Understanding Hedging in Futures

What is hedging?

One of the most important uses of futures is hedging. Hedging means hedge in Hindi. Hedging is used to protect your positions from losses in a bad market. To understand hedging with an example, suppose you have a vacant land outside your house. Instead of keeping this land vacant, you decide to plant a garden in it. You also plant some flowers. Take good care, water regularly and it turns green in no time. Nice lawn and lots of colorful flowers blooming in it. As soon as all this happens, there are some stray cows and other animals that start grazing on the grass of your lawn and destroy your flowers and plants. Then you decide to protect your garden by putting a wooden fence around it so that stray animals can’t harm your garden. This saves your garden.

Now let’s look at this from the perspective of the market.

Suppose you do a lot of research and choose some stocks after careful investigation. By doing them slowly you end up investing a lot of money. Now it is like a garden which you have grown by manuring, watering, maintaining.

After some time of investing your money you feel that there is going to be a fall in the market due to which you may lose. It’s almost like when cows and other animals are about to ruin your lawn.
To protect your investment in the market, you use hedging to avoid loss of money and hence you buy futures. Just like you put a wooden fence around your garden to protect it.

Hope this example gives you some idea of ​​what hedging is all about. As I have said before, hedging is used to protect the stocks in one of your portfolio from losses. Sometimes you can also hedge to protect one of your stocks.

Why to Hedge?

What is the need to hedge? This is a question asked time and again. Just imagine that a trader or investor has bought a stock for ₹100. But now he feels that the market is deteriorating and his stock will also fall. So he can do three things-

• Do nothing, let your stock fall and expect it to return to its current price.
• Sell ​​the stock and hope to buy it again at a lower price later.
• Hedge your position.

First let us understand what happens if one decides not to hedge? Suppose his stock falls from ₹100 to ₹75. Here the trader assumes that one day this stock will reach back to ₹100. So what is the need to hedge when the stock has to reach back to ₹100?

I think you must be understanding that a stock moving from ₹100 to ₹75 means that the stock has declined by 25%. But when the same stock will try to reach ₹75 to ₹100, it will not only have to increase by 25%, it will have to increase by 33.5%. This means that it is easier for the stock to fall but it is more difficult for it to rise back to the old price. I can also tell from my experience that once a stock goes down it takes a very heavy bull market for it to bounce back up. That is why it is always good to hedge whenever you feel that the market conditions are deteriorating.

Now let’s look at the second option where the trader thinks to sell his position and then buy it back at a lower price. For this, first he has to keep a constant eye on the market and enter the market at the right time, which is not easy. Second, when the trader makes frequent buys and sells frequently, he will not get the benefit of capital gains tax. Also, every time you buy to sell, you have to spend on the transaction.

For all these reasons, hedging is always a good way to protect your positions in the market. This means that whatever happens in the market, you will not be affected much. Just like if you have got a vaccine, you will be protected from the disease.

Risk Involve in Hedging

Before we understand how to hedge our positions in the market, it is important that we understand what we are trying to hedge. As you must have understood, we are trying to hedge the risk. But what kind of risk?

Whenever you buy stock of a company in the market, you are taking a risk on your money. There are two types of risk in the market – Systematic risk and Unsystematic risk. When you buy a stock or futures, you are taking both these types of risk.

The stock may fall and it may cost you a loss. There can be many reasons for a stock to fall:

• such as the event of the company’s earnings
• profit margin event
• increase in debt expenses
• increase company leverage
• Management errors or mistakes

There can be many other reasons like this that could lead to a fall in the stock. But what is worth noting here is that all these are risks associated with the company. For example, suppose you invested ₹100,000 in the share of HCL Technologies Limited. After a few months, a statement comes from HCL that its revenue is going to decrease. Because of this statement the price of HCL shares will fall and you will incur a loss on your investment. But this news will not affect the company’s rivals like Tech Mahindra and Mind Tree. Similarly, if Tech Mahindra’s management is caught in any malpractice, the price of Tech Mahindra’s share will be affected, not the shares of any of its rivals. So those risks which are related to a company and then it affects only that company and not any other company, such risk is called unsystematic risk.

Unsystematic risk can be diversified, meaning instead of investing all the money in one company, you can diversify the investment, and invest the same money in two or three different companies. By doing this, the chances of unsystematic risk are greatly reduced. Let’s look at the above example again. So let’s say that instead of investing full money in HCL, you invest ₹ 50000 in HCL and rest of the money in let’s say Karnataka Bank Ltd. In such a situation, if the stock price of HCL falls, then only half of your capital will be affected. Half the capital would still be safe because it is invested in another company. In the same way, instead of two stocks, you can also take shares of 5 or 10 companies and make a portfolio. The more stocks you have in your portfolio for diversification, the lower your unsystematic risk.

Now here comes an important question – how many stocks should you keep in your portfolio so that you can diversify unsystematic risk well. According to the research done so far, a portfolio of at least 21 stocks is required to avoid unsystematic risk. Keeping more than 21 stocks in the portfolio does not reduce the risk further. Take a look at the graph below to understand it better.

As you can see in this graph, as you diversify and add more stocks, the unsystematic risk decreases. But after 20 stocks, unsystematic risk cannot be further diversified. You can also see in the graph that after 20 stocks this graph starts moving in a straight line and there is no change even after adding more stocks. This means that the risk does not decrease after that. In fact, the risk that remains even after diversification is called systematic risk.

Systematic risk is that which occurs not on anyone company but on the shares of all the companies. These are the risks related to the economy that affect the entire market. Some examples of systematic risk are-

• GDP Event
• interest rate hike
• inflation or inflation
• fiscal deficit
• geopolitical risk

This list could be even longer. But by now you must have understood what can happen in Systematic Risk. Systematic risk affects all types of stocks. Suppose you have increased your stock portfolio to 20 stocks and have diversified yourself, but due to a fall in GDP, all 20 stocks may come down. Systematic risk means the risk which is associated with the system and cannot be avoided by diversification. Hedging can be done to avoid systematic risk. So when we talk about hedging, we are not talking about diversification.

Remember we diversify to avoid unsystematic risk and hedge to avoid systematic risk.

Hedging a Stock

We will first learn to hedge in a stock as it is easy to do. By doing this we will also understand its weaknesses and it will be easier for us to hedge the portfolio of stocks going forward.

Suppose you have bought 250 shares of Infosys at the price of ₹ 2284 i.e. you have invested ₹ 571000. This spot is a long position created in the market. After buying the shares, you come to know that Infosys quarterly results are also coming soon. Now you get a little worried that what if Infosys results are not good? Infosys stock will fall and you will suffer. You decide to hedge your position to avoid this loss that can happen in the spot market.

The easiest way to hedge our position in the spot market is to take a reverse position in the futures market. Since we have made long positions in the spot market, we have to make short positions in the futures market.

How to trade short in futures

Short on Futures @ ₹2285/-

lot size = 250

Contract Value = ₹571250/-

Now you have a long position in the spot market in Infosys and a short position on Infosys in the futures market. Although both the positions are formed at different prices, what is more, important than the price of the position is that both your positions are formed in different directions. This means that you are now neutral. You will understand the meaning of being neutral in a while.

Having opened this deal, let us now take a few different prices and see how Infosys reaching those prices will affect this position.

The thing to understand here is that going up or down will not affect your position. You will neither make money nor lose money. This means that today’s position is not going to be affected by the market. This is what we call the neutral position. As I said earlier, hedging a stock position is a very straightforward task and there is no difficulty in it. We can use a counter position in the futures of any stock to hedge its spot position. But to do this, one has to always create such a position in the future in which the number of shares is the same. That is, the lot size of the futures should contain the same number of shares that we have in our spot positions. If there is a difference in the number of shares between these two, then our P&L will be slightly different and the position will not be completely hedged. This raises some important questions-

What if a stock doesn’t have a futures contract? For example, South Indian Bank does not have any futures contract, so does it mean that I cannot hedge my position in South Indian Bank?

For example, the spot position we took to hedge was for ₹570000. But if our position was for ₹50000 or ₹100000, can that position also be hedged?

In fact, the answer to both of these questions is not straightforward. We have to understand them and we will do this work in some time. Now let us try to see how to hedge multiple positions created in the spot. To do this, we have to first understand what is the beta of a stock.

What is Beta

Beta is a Greek word and it looks like β. Beta is widely used in the market. This is a very important principle. This is the right time to understand the importance of beta in the financial market as beta plays a very important role in hedging the portfolio.

Simply put, beta tells how much a stock can be affected by market volatility. From beta, we get answers to questions like-

If the market rises 2% tomorrow, how will this affect XYZ stock?
How much more volatile or risky is a stock XYZ than the market index (Nifty, Sensex)?
What is the higher risk in XYZ stock as compared to ABC stock?

The beta of a stock can be above zero or even below zero. But the beta of a market index is always +1. Now for example, suppose the beta of BPCL stock is 0.7. so that means

For every 1% gain in the market, BPCL stock can rise 0.7%.

BPCL’s stock will rise 1.05% if the market rises by 1.5%.
BPCL stock will fall 0.7% if the market falls 1%.

Since the beta of BPCL stock is 0.3% lower (0.7% Vs 1%) than the beta of the market, it is assumed that BPCL is 30% less risky than the market.

You can also say that BPCL is a low systematic risk stock.

If the beta of HPCL is assumed to be 0.8 percent, then it means that the stock of BPCL is less volatile than HPCL, it means that BPCL is less risky. You will understand it better from the table below

below 0, above 1 like 0.6

Take a look at the beta of some blue-chip stocks as of January 15, 2015.

Removing Beta in Microsoft Excel

In Microsoft Excel, you can easily calculate the beta of any stock by using the =SLOPE function. Here I am showing a step-by-step method to calculate the beta of a stock by taking TCS as an example.

Find out the closing price of Nifty and TCS for the last 6 months per day. You will find it on the website of NSE.

Find out the daily returns of Nifty and TCS.

Daily Return = (Today’s Closing Price / Last Day’s Closing Price) -1

Take the SLOPE function in an empty cell.

The format of the SLOPE function is: SLOPE(known _y’s,known_x’s) Here y’s is the daily return of TCS and x’s is the daily return of Nifty. (SLOPE(known_y’s,known_x’s), where known_y’s is the array of daily return of TCS, and known_x’s )

TCS has a beta of 0.62 for 6 months (3rd Sept 2014 to 3rd March 2015).

You can refer this excel sheet for this calculation.

Hedging of the Stock Portfolio

Now back to the hedging of the stock portfolio. Here we will use Nifty futures for hedging. Here a question may come to your mind that why we are using Nifty futures? Why not use anything else to hedge a stock portfolio?

Remember that there are two types of risk – systematic risk and unsystematic risk. When we diversify our portfolio, we are reducing unsystematic risk. But even after this, the systematic risk remains. As we know Systematic Risk is market-linked, so the best way to avoid it is to use an index which represents the market itself. Hence Nifty futures would be the best way to hedge any type of systematic risk.

Suppose I have invested ₹ 80000 in the market which is engaged in the following stocks-

first step-

Hedging a stock portfolio requires a few steps. The first step is to calculate its portfolio beta.

Portfolio beta is the sum of the weighted betas of all the stocks in that portfolio.
To calculate the weighted beta, the beta of all the individual stocks is multiplied by the weightage of that stock in the portfolio.
To calculate the weightage of a share in a portfolio, the amount invested in that stock is divided by the total investment in the portfolio.

For example, the weightage of Axis Bank is 125,000/800,000=15.6%

Hence its weighted beta will be 15.6%× 1.4=0.21

Given in the table below is the weighted beta of all the stocks in the portfolio

Portfolio beta is the sum of the weighted betas of all the stocks. Here the portfolio beta is 1.223. This means if Nifty goes up by 1% then this portfolio will go up by 1.223%. Similarly, if Nifty goes down, this portfolio will go down by 1.223%.

Calculate the value of the hedge

Hedge value means the amount obtained by multiplying the portfolio beta by the total investment/investment.

= 1.223 × 800,000

= 978,400/-

Remember that this is a portfolio with long positions and these long positions are taken in the spot market. So to hedge it, we have to make a counter position i.e. inverse from long i.e. short position in the futures market. The hedge value tells us that the counter position for this portfolio will be a short position of ₹978400. This is because it is a high beta portfolio.

How many lots will be required

When I was working on this example, Nifty futures was trading at 9025 and its lot size was 25. Hence the contract value of each lot will be

= 9025 × 25

= Rs 225,625/-

This means the number of lots we will need for Nifty futures is

= hedge value / contract value

= 978,400/225,625

= 4.33

From the above calculation we get that to hedge our ₹800000 portfolio we would need 4.33 lots of Nifty. We know we cannot take 4.33 lots. We have to take four lots or five lots, because lots cannot be found in fractions or fractions.

If we take four lots we will be able to hedge a little less and if we take 5 lots we will be hedging more. That’s why we can never make a perfectly perfect hedge.

Now suppose after we hedge, Nifty falls by 500 points (approximately 5.5%). So what will be the effect of our hedge? let’s watch. Here for the sake of this example let’s assume that we are allowed to short 4.33 lots.

nifty position

Shorted @ 9025

Nifty fall – 500 points

Nifty Level – 8525

Lot Quantity – 4.33

P&L = 4.33 ×25×500

= ₹ 54,125/-

So the short of Nifty earned ₹ 54,125/-. But what effect did it have on the portfolio?

portfolio position

Portfolio Value = 800,000

Beta of Portfolio = 1.223

Market fall = 5.5%

Portfolio decline = 5.5% × 1.223 = 6.78%

= 6.78% × 800,000

= ₹54,240

So you can see that on one hand Nifty short position has made a profit of ₹54125 and on the other hand the portfolio has lost ₹54,240. So here, the loss in the portfolio has been equaled by the gain in Nifty.

Now you must have understood how to hedge your portfolio of stocks. You can also see the effect by shorting 4 or 5 lots instead of 4.33 lots in the above example.

Before we conclude this chapter, let us answer the 2 questions that we raised while hedging a position in a stock.

What if a stock doesn’t have a futures contract? For example South Indian Bank does not have any futures contract, so does it mean that I cannot hedge my position in South Indian Bank?
For example the spot position we took to hedge was for ₹570000. But if our position was for ₹50000 or ₹100000, can that position also be hedged?

So the answer is that you can also hedge stocks that do not have a futures contract. For example, suppose you have taken a position in South Indian Bank for ₹ 500000. The first thing you need to do is multiply the beta of this stock and your total investment amount to find the hedge value. Suppose the beta of the stock is 0.75 then the hedge value will be-

500000×0.75

= 375,000

After working out the hedge value, divide this value by the contract value of Nifty to get an idea of ​​how many lots of Nifty you need to short to hedge. Now all you have to do is to make a short position for that number of lots.

As for the second question, if your position is very short and the contract value of Nifty futures is very low, then you will not be able to hedge that position. To hedge such a position, you have to exercise options. Which we will talk about in the next module, when we discuss the options.

Highlights of this chapter

• You can use hedging to protect your positions when the market goes down.
• When you hedge, you make up for the loss in the spot market from the profit in the futures market.
• There are two types of risk in the market – systematic risk and unsystematic risk.
• Systematic risk is linked to the market and the economy. Systematic risk can be hedged. Systematic risk affects all stocks.
• Unsystematic risk is associated with the company. Every company can have its own unique unsystematic risk. To avoid this, you cannot hedge but you can avoid this risk by diversifying.
• Research so far shows that you cannot diversify more than 21 stocks.
• To hedge a position of a stock, all we have to do is create a counter position in the futures market. But the value of that position should be equal to the value of the spot market.
• The market’s beta is always +1.0
• Beta measures the sensitivity of a stock in the market.
• If the beta of a stock is less than 1, it is called a low beta stock.
• A stock with a beta greater than 1 is called a high beta stock.
• You can use Microsoft Excel to extract the beta of the stock. You have to use SLOPE function in that.
• The following steps have to be used to hedge a portfolio of stocks-
• Find out the individual beta of each stock
• Find out the weightage of each stock in the portfolio
• Find out the weighted beta of each stock
• Find the portfolio beta by adding up the weighted beta of all stocks
• Find the hedge value by multiplying the portfolio beta and the portfolio value
• Divide the hedge value by the contract value of Nifty and get the lot quantity
• Short a lot of this quantity in futures.
• Remember it is difficult to hedge perfect so we can only under or over hedge.

Gaurav Heera

Gaurav Heera is a well known name in the field of stock market analysis and education. His distinguished career, which spans more than ten years, has cemented his reputation as an expert with unparalleled knowledge and innovative strategies for navigating the intricate landscape of the financial markets.

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