How can we Hedge Futures in the Stock Market?
What do we understand by the term “Hedge”. The word hedge means protection or covering your risk. In the stock markets, you are exposed to volatility due to factors that are within your control and factors that are outside your control. What you can control is your risk and that is something you can do with hedging futures. How do you hedge futures and how does that cover your risk? Let us understand in detail how to hedge futures?
How to Hedge Futures in the Stock Market?
Hedging futures is the use of futures to hedge your cash market position or any exposure to the market. Remember, it is not just long positions, but even short positions in the market that can be effectively hedged. Hedging futures lies at the core of safe investing in the equity markets. After all, hedging futures is the key to managing your risk; which is what is in your control.
When you buy shares, you stand the risk of notional loss when the prices go down. That is something we have seen so often. Normally, as an investor, you have 3 options when the stock prices move down after you buy.
- Like Warren Buffett, you can say that you don’t care about short-term volatility and hold on. That is normally easier said than done because your blood pressure does shoot up seeing your portfolio value plummeting.
- The other option is to just sell out of the stock and wait for the next signal to buy. However, exit has to be a well-thought-out decision as it entails costs in terms of brokerage, statutory costs, and tax implications.
- Alternatively, you can use the hedge futures approach where you protect the risk of your equity position by selling futures. In hedge futures, you take the opposite position in the futures market.
Hedge futures can be further broken up into different situations. Remember, you don’t hedge futures after the price falls, but you normally hedge futures in anticipation of the price fall. That is when hedging is effective because there is no point in locking the stable doors after the horses have bolted. For hedge futures to be effective, you have got to do it in anticipation or when the signals have just started coming.
Here are 3 situations when you can use hedge futures effectively
- The first approach is to hedge when you see the first signals of the stock falling. Let us say you bought Infosys at Rs.1,250. After you bought the stock, there was some negative news and the stock just broke its support of Rs.1240. This is the time to hedge futures. You can hedge by selling equivalent futures of Infosys in the futures market in the near month or mid-month depending on your view and liquidity. If the stock price goes down then close to the next support you just book profits on the futures position. You have effectively reduced your cost of Infosys stock to the extent of profits on short futures. If Infosys bounces against your expectations, just trigger stop loss on Infosys futures sold. There will be a loss for you but that is the cost to protect your risk.
- The second type of hedge future is slightly different from the first one, although conceptually it remains the same. In this case, you are still long on Infosys but you see risks at a macro level. For example, you anticipate the market to become volatile due to some key events like Union Budget, monetary policy, US Fed meetings, OPEC meetings, etc. Here you can again use hedge futures but instead of using Infosys futures, you sell Nifty futures since you are covering macro risks. Here you can protect from volatility in the overall market and the impact on stocks by using what is called beta hedging, by selling equivalent Nifty futures based on Infosys Beta.
- You don’t just protect your losses but also protect profits. Hedge futures can also be used to lock in profits. Here is how it works. Let us say after you bought the Infosys stock at Rs.1,250, the stock is up to Rs.1,385 in 2 weeks. You are not sure of future direction but want to lock in profits. Further upsides are only possible if Infosys crosses Rs.1,400. What do you do? You sell Infosys futures at Rs.1385 and lock in profits of Rs.135. If Infosys goes above Rs.1400, triggers stop-loss on short futures and holds cash market positions. A better way is to keep your locked-in profits of Rs.135 and keep rolling over the Infosys short futures for arbitrage profits of around 0.8% to 1% monthly.
Of course, hedging using stock futures is meaningful when you are looking at individual stocks which are also available in F&O. Alternatively, if you are looking at non-F&O stocks or a portfolio of stocks, hedging with index futures using beta hedging is more meaningful.
How to check future contract prices?
Futures contract prices are available on the NSE website and also on the trading terminals. You just need to define the exact specification of the futures like which stock or which index and which particular monthly contract (near month, mid-month, or far month). Once that is specified, you can see the futures contract price in front of you on the screen. You can then buy or sell the futures contract at the stated price just like you buy and sell stocks in the market using your trading account.
What is the difference between swaps and futures?
There are several differences between swaps and futures, but first the similarities. To begin with, both swaps and futures are derivative products that derive their value from an underlying asset. Both are contracts and are not assets or asset classes that can be owned. Now for the differences.
- A swap is a contract between two parties that agree to swap or exchange the cash flows on a date set in the future. On the other hand, a futures contract obligates a buyer to buy and a seller to sell a specific asset, at a specific price but deliverable at a future date.
- Swaps are broadly available as interest rate swaps and currency swaps, being most popular. Futures are available as index futures and asset futures and are available for stocks, commodities, and currencies.
- Futures contracts are exchange-traded contracts and are, therefore, standardized contracts with specified maturities and contract parameters. On the other hand, swaps generally are over-the-counter (OTC) products; tailor-made according to specific requirements.
- Futures require a margin to be maintained with the possibility of margin calls in the event margin falls below a certain base level. Swaps are OTC products driven by good faith and reputation and do not have any margin calls in swaps
Frequently Asked Questions Expand All
You can protect your profits either by selling futures on the stock or by purchasing put options on the stock at lower levels. This helps to protect profits but hedging has a cost which you need to bear.
Hedging is meant to make your position in the market safe. It can either be used to limit your losses or it can be used to lock in your profits. Either ways, hedging makes your position safe by shutting down the single side risk of price movement. Of course, hedging does come with a cost involved.
The beta of the market is always one, which is the beta of the general index like Nifty or Sensex. Every stock has a beta that can be aggressive i.e., more than 1 or the beta can be defensive i.e., less than 1. If Beta is 1.2, it means that a 1% move in the index will bring about a 1.2% move in the stock.