Investments in financial markets depend on the investor’s anticipation. Anticipation sometimes turns out to be right and sometimes it is wrong. If your anticipation is correct about your investment, it is obvious you will make a profit but what if it goes wrong? You have to land up in losses, isn’t it? To mitigate these losses, hedging is used in the financial market. Hedging is crucial for managing risk involved in the Financial markets and if you want to learn What Is Hedging In Stock Market? Here is an article that will give you intricate details of how hedging works.
What Is Hedging? How does Hedging work?
Hedging can be described as a financial market’s practice which is used to prevent the losses. The market is volatile and to safeguard the interest of the investors, this method is used. It can be easily explained comparing it with insurance where the insured person reduces his or her losses which arises out of an uncertain event with the help of the insurance. Similarly, hedging reduces the losses of an investor which crops out of market fluctuations.
There are mainly three kinds of hedging in the stock market which are –
- Futures Contract: In the commodities market, hedging is a regular affair. A futures contract is an integral part of this market. This can be described as standardized agreements between two independent investors. They agree to buy an asset of a specified amount at a predetermined price on a future date. These agreements are mostly drawn for currencies, commodities and other asset classes. Futures contracts drawn on indexes are known as index futures.
- Forward Contracts: This is similar to Futures contracts however these are not standardized agreement.
- Options Contracts: Options are derivative contracts, that offer the buyer a right to enter a contract to buy or sell stock at a specific date and price.
Hedging can be done in a different manner using the above written financial instruments and derivatives available in the market. The most common type of hedge is done using Futures contracts and options. For example, you can use the stock future to go short on an equity index if you are predicting a market correction. This would help your portfolios to not loses money and value.
Another simple way of hedging is by using stocks. For instance, using stocks you can hedge by taking a long and short position on the same equity security. When you buy shares you are going long on that share and similarly, if you are shorting the shares you are borrowing the shares and selling them in the open market. If the stock price falls, your short position’s value increases as you can buy the shares from the open market for less money than the amount you got shorting your shares. You can also use the shares already bought to return the shares to the borrower. In any case, your investment is protected from downside price risk. Similarly, when the stock price rises, your long position value increases.
Hedging cannot completely safeguard you from the losses but it can definitely lessen the amount of loss.
For instance, you think that the Automobile industry is about to perform great in the upcoming years and thus you buy 500 shares of TATA Motors. The price of one share is Rs. 2000 and thus your total investment stands at Rs. 1000000.
However, with the recent budget and the anticipation of increasing prices of cars, you feel that the position you have taken can incur losses. In this case, you can buy a put option of Rs. 1800 maturity May 2019 which means you can sell the Tata Motors shares at Rs. 1900 before May 2019 ends. You have bought 5 put options and each lot is of 100 shares. For one put options, you pay Rs. 5000 so for 5 it is Rs. 25000.
Now two things can happen either the price of Tata Motors will increase or it will decrease. If it increases to Rs. 2200 each share from your original investment will be worth Rs. 1100000. However, if the price falls to Rs. 1700, then the value of your investment would be Rs. 850000 which is at a loss of Rs. 150000. But you have put options whose value is Rs. 950000, if you deduct the cost of the premium that is Rs. 25000, your total value stands at Rs. 925000 where. So, your loss would be minimized to Rs. 75000 because of your hedge.
This is one of the hedging strategies which is known as Married Put, these strategies are discussed below.
What is an Equity Derivative?
Equity Derivatives are another important part of the hedging process in the stock market. This is a financial instrument that derives value from the underlying asset’s price movement. The underlying asset for equity derivatives is equities or share prices. Using equity derivatives you can hedge your positions (long and short) in the stock market.
What are the various option strategies used for hedging?
Option contracts are financial derivatives and equity derivatives are a part of options. So, these contracts give you the right but not oblige you to buy or sell an asset at a predetermined price on or before the expiration date of the contract. If you are investing in the right to buy then that is a call option and if you are taking a right sell then that is a put option. The value of these contracts is determined by the price movements of the underlying assets. Equity derivatives are those options which have shares as underlying. Hedging with options is one of the common practice in the market and here are ten strategies to hedge using options.
This is a combination of purchasing a put option and stock position together on the same day. This works and reduces your losses when the price of the stock fall below the strike price of the put. This is beneficial for the investors who want ownership rights, voting rights of the company but also worried about market twists and turns. This is what has been explained in the example above.
Bear Put Spread:
You can implement this strategy by buying an in-the-money put option with higher strike price and selling an out-of-the-money put option with a lower strike price which has the same underlying asset and expiration date. This will help the trader to diminish the expense of getting into a bearish trade position.
The bull call spread:
This can be done by buying a call option which is at-the-money and at the same time selling an out-of-the-money call option with a higher strike price of same expiration and underlying. This will help in reducing the cost of the trader for getting into the bullish position.
A Covered Call strategy can be implemented by buying and holding the underlying asset and selling call option of the same underlying. This helps the trader to enjoy the ownership of the underlying stocks and also reduces his chances of losing money on the asset if the price falls. It can be done with out-of-the-money call options as well as in-the-money call options.
You can sell out-of-the-money call options while you do not have any underlying asset. It is beneficial when the trader is slightly bearish on the underlying asset. It helps in recovering the premium of the option when they expire without any worth and this can be continued till the market remains the same. It can be done other way around using the in-the-money call options which are deep-in-the-money and you sell them without the underlying security in hand. This is also done for the same benefit.
It can be done by holding underlying assets, and at the same time buying the protective put options while selling the call option against the underlying that you are holding. Both the options must have the same expiration and the number of contracts must be equal in them. This helps in earning the premiums of the options and also safeguards from an uncertain steep drop in the price of the underlying asset.
This is a simple strategy which can be implemented by buying put and call option of the same strike price of the same underlying with the same expiration date. This strategy is useful in a highly volatile market as expected by the trader and it provides either unlimited profit or limits the risk of the potential loss.
Long call butterfly spread:
This is a neutral strategy that combines a bull and a bear spread. It helps in achieving limited profit but also help in limiting the losses. This strategy is constructed using call and put options. For this, you have to buy one in-the-money call option with lower strike price and sell off two at-the-money calls and then buy another out-of-the-money call with a higher price.
This can be done by combining a bull put spread and a bear call spread. This is for limiting the losses and gaining small profit which is also limited when there is a lower amount of volatility in the underlying asset’s price.
This strategy is also used to limit the risk of trade and this strategy can be constructed by buying an out-of-the-money put option with a lower strike price, sell put and call options which are at-the-money and then buy an out-of-the-money call with higher striking.
What are Hedge Funds?
A hedge fund is a non-regulated fund that use various derivatives to hedge risks. These are mostly privately held, unlike the mutual fund which is government regulated in most cases. While hedging a portfolio is the process, hedge funds are those portfolios or funds on which hedging is done.
Hedging is pivotal to the stock market investment as well as to the risk managers as every investor wants to safeguard his or her money being lost in the market fluctuation. Using the simple to complicated strategies and hedging techniques, you can enjoy the profits of a trade as well as limit your losses and that is only possible when you hedge.
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