Hedging Basics

Hedging in everyday life.

Hedging is like insurance we take on our life, health, and vehicle.

The reason we take insurance is not cause of we want something bad to happen to our

• dear life
• dear health
• car/bike/bicycle

Human beings are some exceptional creatures who love to be in control of their situation, or even if they are not, they need an assurance that things are okay and are going in the way they expects. Uncertainty is something that people are afraid of, Uncertainty kills him.

So insurance came into existence cashing in on this human behavior flaw.

Common examples of hedging in real life would be

• Life insurance policies
• Health insurance policies
• Calling your employed sister for recharge hedge
• Friend’s number for “I forgot my purse at home” Hedge, while having the lunch in an expensive restaurant ,list goes on
• Lights for darkness
• That extra pen you carried for your last exam ,even though the one you are using to write works fine
• This list can go on, but then expression would be lost in translation, even though the concept is the same, financial hedge is not that easy as it does not sound nor it is as hard as an expert would tell you it is.

Depiction of Life Insurance/ Financial Hedge Instrument

Asset =You / Stock

Risk =your dear life / Value of Investment

Hedge=Insurance Contract / Derivative Contract

Hedging Stock Market Context

Bringing the same fashion into Investment, nobody wants to invest and worry from day one, would my money be perished. So capital market offers this via in the form of futures market.

Instruments traded here are contracts, not actual assets.

Hence they got the name derivatives, why? Apparently they derive the value from something else.

So what’s the something else here?
That could be

• Bundled stocks of company - Index
• Company Stocks - Stock Futures
• Insurance on portfolio position -Stock options/Index Option 

Though last one is not a complete example for the time being it would do, aren’t we talking to the layman sir here.

Other instruments

• Interest Rate SWAPs
• Currency Derivatives
• Debt derivatives

Note:Though primarily designed as a safety instrument, this has grown into become an segment of its own, most time out numbering the cash market.
Now the traders can trade these contracts alone, no questions asked about purpose. (Carries considerable amount of risk)

Hedging in Any Market

We can make it as much complex as we can make it, for the time being let’s stick to the Layman

Story line

• He invest in some shares set up his portfolio,
• so as the time moves on his portfolio looks like this

as on present day .

Company -Qty ————-CMP——————Market Value

X ————100—————20———————2000/-

Y————-200—————100——————-20,000/-

So on one fine morning, he thinks by this month end, he want to sell these shares at present market value. IE = He want to fetch 22,000/- from sale.

• But market is not in any obligation to stable the price for him alone. So his decision carries a risk, that he was not expecting, which is depletion in market value.
• This risk is something that is covered using hedging, risk that how he can protect his planned sale in future so that he would never be at loss.
• So here, he reduces the risk by purchasing corresponding hedge instrument -Put option in this case.
• But as there are no free lunches, he has to pay for this risk management; you can compare this to Premium paid on insurance. 

In summary what you did?

You were not sure of the value depreciation

• You took that risk
• handed over to someone else
• paid a premium to receive such service
• win/win for both
• For you : Protection
• For Contract Seller : Premium earned

From a trader perspective: Events & Action List

Shorts 100 shares at  $ 100

• He fears trade can go against him
• He buys calls out of money to protect him for 100 shares by paying premium

This is because

• If stock travels above his shorting - His call option will protect him
• If stock stagnates -he would incur the loss of call option premium
• If stock goes down as he expects his actual profit would be

= Profit from shorting - Premium paid on calls

This is only one of the many methods, depending upon the situation; with complex setups an infinite number of combinations of these contracts can be tried. 

Some classic hedges are below

• Portfolio price is expected to be down = Buy Puts
• Stock planned to acquire in future is in upward trend = Buy call —from Currency derivatives

To list each event is not academically possible. How we do hedge is via understanding the proper dynamics of each .In Indian context Index hedge are done plenty ,since futures & options in Stocks are screened .

To properly hedge on your own you need to have a proper understanding of the below

• Stock beta
• Greeks of options
• Futures
• Strategies in hedging
• Past pattern of the stock in question
• Latest development in news front regarding industry & company.

It’s only inclusive list, you can add more variables as you require.