In stock market terminology, hedging refers to an investment which is made solely to reduce the risk in an asset. For stock market investors, it is similar to buying insurance for your portfolio which will protect the investor during a market crash or correction.
Why is hedging done?
Hedging is used by investors to protect their capital from stock market corrections or crashes. It can be an effective strategy to limit your losses during uncertainties in the equity market. A hedging is generally used by investors when they expect a volatile market movement due to any major geopolitical or major financial event in the world. The entire idea of hedging is to protect the losses which you can suffer on your portfolio by paying a small price like an insurance premium!
Do only investors use hedging? Or can companies use hedging as well?
Yes, hedging is used extensively by companies which have high exposure to assets with fluctuating prices. Companies which deal with commodities always use hedging to protect themselves from major losses. Consider the following example of Titan.
Suppose the company Titan buys gold which it intends to use to produce gold jewelries. Titan buys gold on 1st February at Rs. 50,000 per 10 grams and stores it in its inventory. Suppose the entire process of converting gold bars in an investor to jewelries in a store takes around 2 months. While the company was working on processing the gold bars to create jewelries, they found out on 15th March that the gold price has fallen 20% to Rs. 40,000 per 10 grams. The company took a 20% loss on its entire inventory of gold due to change in gold price. Surely the customer is not going to pay more for gold just because the company bought the gold at a higher price! Titan just took a massive loss due to fluctuation in gold price.
Let’s take another example. Suppose a small jeweler got an order to make 15 necklaces in one month. The customer has paid an advance to the jeweler based on the current price of gold (let’s say current price of gold is Rs. 50,000 per 10 grams). The jeweler buys the 5 days after the order was confirmed by the customer and found that the gold price has increased to Rs. 55,000 per 10 grams! This means that the jeweler has to buy gold at Rs. 55,000 and sell it to the customer (who has paid the advance) at Rs. 50,000. The jeweler suffers a massive loss and has to shut down his/her shop!
Both of these scenarios could have been avoided by hedging! Companies like Titan always use gold futures to hedge their inventory against gold price fluctuations. Imagine the same scenarios faced by Titan & jeweler but this time they have used a proper risk management technique of hedging!
Stock market terminology of “long” and “short” will be used in the following examples. If you are not aware of these terminologies, visit this article!
Suppose the company Titan buys gold at Rs. 50,000 on 1st February at Rs. 50,000 per 10 grams and stores it in its inventory. On the same day, they short an equivalent amount of gold futures as a hedging tactic. By shorting the price, Titan can sell the same amount of gold at Rs. 50,000 per 10 grams on a future date. When the price of gold falls to Rs. 40,000, they take a 20% loss on their entire inventory. But since Titan has hedged using gold futures, they make a profit of 20% (equal to their loss in physical gold) on their future contract! Overall the fluctuation in the price of gold gets nullified and the company prevents a massive loss.
Considering the second example, suppose the small jeweler got an advance order of 15 necklaces at a price of Rs. 50,000 per 10 grams of gold. The jeweler is smart & he immediately buys an equivalent amount of gold futures for Rs. 50,000. By going long on gold futures, the jeweler can buy the same amount of gold at Rs. 50,000 per 10 grams on a future date. When the jeweler goes to buy gold after 5 days, he takes a big loss due to the increase in the price of gold to Rs. 55,000. However, his hedging position in gold futures provides him the exact same profit of 10%. So, the overall effect gets nullified and the jeweler prevents a massive loss.
One important thing to note here is that both Titan and the jeweler used gold futures to hedge their position in the physical gold. The intent of this hedge was never to make a profit! Hedging position was made solely to reduce any risk due to the fluctuating price of gold. Even if the situations were reversed, say price increased after Titan bought their gold inventory, the overall profit and loss would still nullify. In this case, the increase in inventory price will be offset by the losses made in gold futures. The entire concept of hedge is to nullify the effect of price fluctuations, not to make a profit!
What kind of risks can be avoided by hedging?
Many risks can be avoided by the hedging technique such as
- Currency risks – due to the strengthening or weakening of Rupee against the US dollar.
- Commodity risks – due to the fluctuating price of commodities such as steel, gold, copper, etc.
- Inflation risks – due to the rise in price of goods which leads to reduction in purchasing power.
- Interest rate risks – due to the change in interest rates which are decided by the central bank of the country (such as RBI for India)
Any risks which involve a fluctuation in the underlying asset’s price can be reduced by hedging.
Are there any downsides of hedging?
Absolutely! A bad hedge position can erode the profits of an investor and can even cause big losses. Hedging works both ways. Since hedging is an opposite trade to your current investment position, it will reduce your profits! The hedge only works when things go opposite to you expectation. Hedging has a clear negative effect when the market goes as per the expectation of the investor.
How can I hedge to reduce the risk to my portfolio?
Stock market investors have a risk of losing their capital during market corrections and crashes. Investors can use futures and options contracts to protect themselves from risks. To learn more about options, visit this article!
Hedging strategy 1 – Futures
Suppose your investment portfolio is worth Rs. 10 Lakhs. You think that the stock market can fall significantly which can cause a major loss to your portfolio. You don’t want to take a major loss, so you decide to set up a hedge! You short Nifty futures to create a hedging position. There are only two possible scenarios –
- The market rallies – Your portfolio appreciates in value. However, your hedging position leads to a loss. You paid the insurance premium in hopes of something catastrophic but nothing bad happened. In short, you only lost some of your profits to offset your losses in the futures contract.
- The market falls – Your portfolio depreciates in value. This is where the hedging position will come to your rescue. You lost money on your portfolio but you made money on your hedge!
Hedging strategy 2 – Options
Suppose your investment portfolio is worth Rs. 10 Lakhs. You think that the stock market can fall significantly which can cause a major loss to your portfolio. You don’t want to take a major loss, so you decide to set up a hedge! Typically, you can use 0.5-1% of your portfolio size to buy put options. You use Rs. 10,000 to buy Nifty put options to set up a hedging position.
There are only two possible scenarios –
- The market rallies – Your portfolio appreciates in value. But there is a decay in the premium for the put option. You lose some of your profits to offset the decay in premium.
- The market falls – Your portfolio depreciates in value. This is where the hedging position will come to your rescue. The value of the put option can increase multi-fold depending on the severity of the fall. You were able to avoid the risk using options hedging.
Can an investor make money using hedging?
No, the investor should not set up a hedging trade in the hope of making a profit. The entire idea of using a hedge should be to protect the portfolio of the investor. If futures and options are used for the purpose of making a profit, that’s F&O trading and not hedging!
Hedging should be considered as an insurance of the portfolio. Think of it like your health insurance. You pay a small amount to protect yourself from any health issues in the future. Trying to make money in hedging is similar to deliberately breaking your legs to make money from your health insurance. Not a great idea!
When should investors use hedging?
Investors should only use hedging when they expect the stock market to go opposite to their expected direction. Suppose you are a long term investor who has invested a big amount in the stock market. You are worried about the effect of a potential war between countries, scams, political changes, etc. on your portfolio. In such a situation, you can use a hedge to protect your portfolio for a particular time duration.
Conclusions
Hedging is a great risk management tool which is used by stock market investors to protect themselves during uncertain situations. However, such a tool should not be used unnecessarily because it leads to erosion of a portfolio’s profits. The usage of hedge using futures or options contracts depends entirely upon the reader based on their judgement.
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DISCLAIMER : I am not a financial advisor. I am not for or against any company which I have mentioned in this article. All the information provided here is for education purposes. Please consult a financial advisor before investing.
Contact me at investmentabshuru@gmail.com
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