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• Nifty futures
• Nifty futures
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• Hedging with futures
• Notes

11.1 – Hedging, what is it?

Hedging is among the most significant and useful uses of futures. Hedging is an easy way to avoid suffering a loss on your trading positions in the event of any unfavorable market fluctuations. Let me try to explain the concept of hedging to you using an analogy. Just outside your home, let’s say you have a little patch of empty, barren land. Rather than letting it remain empty and bare, you decide to grass the entire area and plant a few lovely floral plants. You tend to the tiny garden, give it regular waterings, and watch it flourish.

Your efforts eventually pay off, the lawn turns a beautiful green color, and the flowers begin to bloom. As the plants develop and the flowers begin to blossom, unwanted attention begins to gather. You quickly discover that a few stray cows have made your small garden one of their favorite hangouts. You see these wandering cows happily grazing on the grass and trampling the lovely flowers. You decide to defend your tiny garden since you’re so irritated by this. What you envision is a straightforward solution—you build a fence (perhaps a wooden hedge) around your garden to keep cows out. By using this simple workaround, you can protect your garden while allowing it to grow.

Now let’s apply this comparison to the markets:

Imagine managing a portfolio by selecting each stock after thorough research. You gradually deposit a substantial sum of money into your portfolio. This is comparable to the garden you cultivate.
After investing your money in the markets, you eventually learn that the markets may soon enter a volatile phase that would cause portfolio losses. This is similar to a wandering cow ruining your lawn and flower plants by grazing there.
You build a portfolio hedge using futures to stop your market holdings from losing money. This is the equivalent of building a wooden fence to enclose your garden.

I believe the aforementioned comparison adequately conveyed what “hedging” entails. Hedging, as I had previously indicated, is a strategy to guarantee that any negative market movements won’t have an impact on your position. Please don’t think that hedging is just used to safeguard a stock portfolio; you may actually use a hedge to protect specific stock positions, albeit with some limitations.

11.2 – Hedge – But why?

Why genuinely hedge a position is a subject that comes up regularly when hedging is brought up. Think of this: A trader or investor has a stock that he paid Rs. 100 for. He now believes that both the market and his stock are going to drop. In light of this, he has the option of doing one of the following:

Let his stock fall without taking any action in the hopes that it would ultimately rise again.
Sell the stock with the intention of later purchasing it for less money
Leverage the situation

Let’s first examine what actually transpires when a trader chooses not to hedge. Imagine your investment in the stock drops from Rs. 100 to, say, Rs. 75.

Additionally, we’ll assume that eventually, as time goes on, the stock will return to Rs. 100. The key question is: Why should one actually hedge when the stock eventually returns to its original price?

You would probably agree that the decrease from Rs. 100 to Rs. 75 represents a 25% decrease. But if the stock needs to move back from Rs. 75 to Rs. 100, it won’t be a scale back of 25%; instead, it will move back by 33.33 percent to meet the initial investment value! This indicates that while it involves less work to lower a stock’s price, it takes more work to restore it to its previous level.

Additionally, I can tell you from experience that equities do not typically increase that quickly unless there is a bull market in full swing. For this reason, it is usually wise to hedge positions anytime one predicts a pretty massive adverse market movement.

What about the second choice, though? The second alternative, in which the investor sells the stock and then buys it again at a later time, necessitates market timing, which is difficult to achieve. In addition, a trader who engages in frequent transactions will not profit from long-term capital tax. Naturally, frequent transactions also result in higher transaction costs.

Hedging makes sense for all of these reasons because it virtually insulates the position in the market, making it irrelevant to what actually occurs in the market. It is comparable to receiving a viral vaccination shot. Therefore, when a trader hedges, he may be sure that the market’s negative movement won’t have an impact on his position.

11.3 – Risk

It’s probably vital to know what we are aiming to hedge before moving on to understanding how we could hedge our market positions. We are hedging the risk, as you can probably guess, but which kind of risk?

In essence, you take on risk when you purchase a company’s shares. Systematic risk and unsystematic risk are the two main categories of risk. Purchase of a stock or a stock future exposes you to these dangers at the same time.

There are several reasons why the stock could decrease, costing you money. reasons like –

declining sales
declining margins of profit
higher cost of financing
maximum leverage
management incompetence

All of these factors carry some level of danger; in fact, there may be many more factors that are similar, and the list might go on. You’ll notice that each of these risks has one thing in common: they are all company-specific concerns. Imagine, for instance, that you have Rs. 100,000 available for investment. You choose to invest in HCL Technologies Limited with this capital.

A few months later, HCL declares that its sales have decreased. It is apparent that the price of HCL stock would decrease. It implies that your investment will be lost. The stock price of HCL’s rivals Tech Mahindra or Mindtree won’t be by this announcement, though. Likewise, Tech Mahindra’s stock price will decrease and not that of its rivals if the management engages in any misbehavior.

Unsystematic risk can be , which means you don’t have to put all of your money into one business. Instead, you can opt to invest in two to three different ones (preferably from different sectors). Unsystematic risk is significantly diminished when you do this. Going back to the previous scenario, imagine that you choose to purchase HCL for Rs. 50,000 and perhaps Karnataka Bank Limited for the remaining Rs. 50,000 instead of purchasing HCL for the entire capital.

In such a case, even if the price of HCL stock drops (because to unsystematic risk), the investment will only suffer losses on half of it because the other half is in a different firm. In reality, you can have a portfolio of five stocks, ten stocks, or even twenty stocks instead of simply two. Your portfolio’s diversification will be greater the more equities you have, which will reduce the unsystematic risk.

This brings us to a crucial question: How many stocks should a decent portfolio contain in order to completely diversify the unsystematic risk? According to research, a portfolio with up to 21 stocks will have the essential degree of diversification, and anything more than that may not significantly contribute to diversification.

As you can see from the graph above, diversification and adding more stocks significantly lower the unsystematic risk. The line begins to flatten out at 20 stocks, indicating that the unsystematic risk is not really diversifiable after that point. In fact, the “Systematic Risk” is the risk that persists even after diversification.

The danger that all equities share is as systemic risk. These macroeconomic concerns typically have an impact on the entire market. A few examples of systemic risk are:

decline in GDP
increases in interest rates
Inflation
fiscal shortfall
geographic risk

Of course, the list is not exhaustive, but I think you now have a good sense of what systematic risk is. Every stock is subject to systematic risk. A decrease in GDP will therefore undoubtedly have an impact on all 20 equities in a well- portfolio, and as a result, they are all likely to experience a loss. Because it is a part of the system itself, systemic risk cannot genuinely be . Systematic risk, however, can be “hedged.” Therefore, keep in mind that diversification and hedging are not the same things when we discuss hedging.

It’s important to keep in mind that we diversify to reduce unsystematic risk and we hedge to reduce systematic risk.

11.4 – Hedging a single stock position

We’ll start by discussing hedging a single stock future because it’s quite easy to do so. We shall also comprehend its limitations before moving on to comprehending how to hedge a stock portfolio.

Consider purchasing 250 shares of Infosys at a cost of Rs. 2,284 each. This amounts to an Rs. 571,000 investment. You are definitely “Long” Infosys in the spot market. You understand the quarterly results are due soon after starting this employment. You are that Infosys might release some unfavorable financial data, which would cause the stock price to drop significantly. You choose to hedge the position in order to prevent suffering a loss on the spot market.

Simply entering a counter position in the futures market will allow us to hedge the spot position. We must be “short” in the futures market because the spot position is “long” at this time.

The short futures trade specifics are as follows:

Long Futures @ 2285/-

Lot size is 250.

Value of the Contract: Rs. 571,250

Though at separate prices, you are currently long Infosys (in the spot market) while we are short it (in the futures price). However, since we are “neutral” in terms of direction, the price variation is unimportant. You’ll realize what this implies soon enough.

The important thing to remember is that the position will not profit or lose money regardless of where the price is headed (whether it rises or falls). The general situation appears to be . In fact, the position loses interest in the market, which is why we say that when a position is hedged, it continues to be “neutral” with regard to the state of the market as a whole.

Hedging a single stock position is quite simple and hassle-free, as I had already said. To hedge the position, we can use the stock’s futures contract. However, one needs to have the same number of shares as the lot size in order to use a stock futures position. If they change, the P&L will change and the position won’t be ideal.

This raises the following crucial inquiries:

1. What if I hold shares of a stock that isn’t by a futures contract? Does the absence of a futures contract, for South Indian Bank, imply that I cannot hedge a spot position in South Indian Bank?

2. The spot position value in the example was Rs. 570,000. However, what if I hold relatively minor positions, like Rs. 50,000 or Rs. 100,000? Can I hedge such situations?

In actuality, neither question’s answer is quite simple. Soon we shall comprehend how and why. We’ll move on to learn how to hedge several spot holdings for the time being (usually a portfolio). To begin, we must comprehend something referred to as the “Beta” of a stock.

11.5 – Understanding Beta (β)

Beta, represented by the Greek letter, is a very important concept in market finance because it is in many different areas of that field. Given that beta is to hedge stock portfolios, I believe the time is right to introduce it.

Simply said, beta evaluates how sensitive a stock’s price is to changes in the market, which means it can assist us to respond to queries like these:

What is the in stock XYZ if the market rises by 2% tomorrow?
In comparison to market indices (Nifty, Sensex), how risky (or volatile) is the stock XYZ?
In comparison to stock ABC, how hazardous is stock XYZ?

A stock’s beta might have any value above or below zero. The market indices (Sensex and Nifty) have a constant beta of 1, nevertheless. If, for instance, the beta of BPCL is +0.7, the following implications are made:

BPCL is to gain by 0.7 percent for every +1.0 percent increase in the market.
BPCL is to increase by 1.05 percent if the market increases by 1.5 percent.
BPCL is to experience a reduction of 0.7 percent if the market falls by 1.0 percent.

1. BPCL is to gain by 0.7 percent for every +1.0 percent increase in the market.

BPCL is to increase by 1.05 percent if the market increases by 1.5 percent.
BPCL is to experience a reduction of 0.7 percent if the market falls by 1.0 percent.

2. It is thought that BPCL is 30% less hazardous than markets because its beta is 0.7 percent versus 1.0 percent, a difference of 0.3 percent.

One may even claim that BPCL has a lower overall systematic risk.

3. BPCL is thought to be less volatile than HPCL, making it less risky, if HPCL’s beta is 0.85 percent.

11.6 – Calculating beta in MS Excel

Using the Excel function “=SLOPE,” you can quickly determine the beta value of any stock. Here is a step-by-step formula for doing that; I used TCS as an example.

Download the Nifty and TCS daily close prices for the previous six months. This is available from the NSE website.
Determine the Nifty and TCS daily returns.

1. Daily return is as [Today’s Close / Yesterday’s Close]

-1

3. Enter the slope function in a cell that is empty.

The slope function is as =SLOPE(known y’s, known x’s), where known y’s is an array of TCS’s daily returns and known x’s is an array of Nifty’s daily results.

4. 6-month beta for TCS (3rd September 2014 to 3rd March 2015) calculates to 0.62.

11.7 – Hedging a stock Portfolio

Let’s get back to the topic at hand, which is using Nifty futures to hedge a portfolio of stocks. Before we continue, you might be wondering why we should utilize Nifty Futures to hedge a portfolio. Why not another option?

Do not forget that there are two categories of risk: systematic risk and unsystematic risk. A diverse portfolio naturally helps us to reduce unsystematic risk. The systemic risk is what is left after this. The greatest strategy to protect against market risk is by using an index that represents the market, as systematic risk is the risk connected to the markets. The Nifty futures are a logical choice to reduce systematic risk as a result.

Initial Step: Portfolio Beta

Hedging a stock portfolio entails a number of stages. Calculating the total “Portfolio Beta” is the first stage.

The “weighted beta of each stock” is to determine the portfolio beta.
By combining the beta of each individual stock with its corresponding weight in the portfolio, weighted beta is.
By dividing the amount invested in each stock by the total value of the portfolio, the weighting of each stock in the portfolio is.
For instance, Axis Bank’s weighting is 15.6 percent (125,000/800,000).
As a result, Axis Bank’s weighted beta on the portfolio would be 15.6 percent * 1.4 = 0.21.

The overall Portfolio Beta is the weighted beta together. The beta for the portfolio mentioned above is 1.223. This indicates that if the Nifty index increases by 1%, the portfolio as a whole are anticipated to increase by 1.223 %. Similarly, if the Nifty declines, the portfolio is anticipated to decline by 1.223 percent.

Calculate the hedging value in step two.

Hedge value is just the sum of the portfolio’s entire investment and its beta.

= 1.223 * 800,000

= 978,400/-

Remember that we bought these stocks on the spot market, and this is a long-only portfolio. We are aware that taking a counterposition in the futures markets is necessary for hedging. The hedge value recommends that a portfolio worth Rs. 800,000 should be hedged. We must sell futures contracts worth Rs. 978,400. Given that the portfolio is a “high beta portfolio,” this should be rather obvious.

Calculate the necessary number of lots in step three.

With the current lot size of 25, the contract value per lot for Nifty futures, which are currently trading at 9025, is equal to –

= 9025 * 25

= Rs.225,625/-

Therefore, there would be tonnes needed to short Nifty Futures.

= Contract Value / Hedge Value

= 978,400 / 225625

= 4.33

According to the calculation above, 4.33 lots of Nifty futures must be sold short in order to perfectly hedge an investment portfolio worth Rs. 800,000 with a beta of 1.223. As we can only short 4 or 5 lots, and fractional lot sizes are not available, it is obvious that we cannot short 4.33 lots.

We would be just a little under-hedged if we choose to short 4 lots. Similarly, if we sold five units, we would have over-hedged. We actually can’t always perfectly hedge a portfolio for this reason.

Now, suppose that after using the hedge, the Nifty actually drops by 500 points (or about 5.5 percent ). We will use this information to determine the hedge’s effectiveness in the portfolio. I’ll suppose we do it for the sake of illustration.

Position Nifty

the short started at – 9025

Value Reduction – 500 points

8525 is the Nifty value.

There are 4.33 lots total.

P & L = 4.33 * 25 * 500 = Rs.54,125

The short position has made a profit of Rs. 54,125. We will investigate what might have occurred with the portfolio.

Portfolio Place

Portfolio Value is 800,000 rupees.

Portfolio Beta equals 1.223

Market decline: 5.5 percent

Expected Portfolio Decline = 5.5 percent multiplied by 1.233 to equal 6.78 percent

800000 divided by 6.78 percent

= Rs. 54,240

As a result, as you can see, the Nifty short position has made a profit of Rs. 54,125, while the long portfolio has suffered a loss of Rs. 54,240. The net position in the market is therefore unchanged (please overlook the slight difference). The gain in the Nifty futures position cancels out the loss in the portfolio.

I hope this has helped you better understand how hedging a stock portfolio works. I would advise you to perform the same exercise with 4 or 5 lots in place of the 4.33 lots.

Let’s examine two outstanding questions that we posed when we explored hedging single stock positions before we conclude this chapter.

In order to make it easier for you, I’ll repost it here:

What if I hold shares of a stock that isn’t covered by a futures contract? Does the absence of a futures contract, for South Indian Bank, imply that I cannot hedge a spot position in South Indian Bank?
What if I have relatively minor stakes, say, Rs. 50,000 or Rs. 100,000? Can I hedge such positions? In the example taken, the spot position value was Rs. 570,000.

You can, however, hedge stocks that lack stock futures. For illustration, let’s say you own South Indian Bank stock valued Rs. 500,000. To find the hedge value, all you have to do is multiply the stock beta by the investment value.

Considering that the stock’s beta is 0.75, the hedging value is

500000*0.75

= 375,000/-

Once you’ve this, divide the hedge value by the Nifty’s contract value straight to determine how many lots are needed (too short) in the futures market. With this information, you can properly hedge the spot position.

Regarding the second query, the answer is no—you cannot hedge tiny bets whose value is far below the contract value of the Nifty. However, you can use options to hedge such holdings. When we consider our possibilities, we shall talk about the same.

CONCLUSION

By hedging, you may protect your market position from any negative market changes.
Gains in the futures market are used to offset losses you incur when hedging in the spot market.
Systematic and unsystematic risk are the two different categories of risk.
The risk that is unique to macroeconomic events is called systematic risk. The risk posed by systems can be hedged. All stocks are subject to systematic risk.
The company’s risk is known as unsystematic risk. Every business is different in this way. Although it cannot be hedged, unsystematic risk can be diversified.
According to research, unsystematic risk cannot be further diversified after 21 stocks.
We only need to take a counter position in the futures market to hedge a single spot equity position. But spot value and futures value must be equal in size.
Beta for markets is always +1.0.
The stock’s sensitivity is measured by beta.

1. Low beta stocks are those that have a beta of less than 1.

2. A high beta stock is one that has a beta greater than 1.

10. Using MS Excel’s “Slope” tool, one may quickly estimate the stock beta.

11. The actions below must be taken in order to hedge a portfolio of equities.

Calculate each stock’s beta.
Determine each stock’s individual weighting within the portfolio.
Identify each stock’s weighted beta.
To calculate the portfolio beta, add up the weighted beta.
To calculate the hedge value, multiply the portfolio beta by the portfolio value.
To determine the number of lots, divide the hedging value by the Nifty Contract Value.
In the futures market, short the required number of lots.

12. Remember that creating a perfect hedge is challenging, thus we are obliged to either under a hedge or over a hedge.

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Hedging with Futures