Hedging is protecting your portfolio from value erosion. Hedging acts like insurance for your portfolio. If any untoward event happens, your portfolio would be unaffected to a large extent. This way, your portfolio could be protected from big market crashes, stock specific negative events like disappointing results and other events that could bring down the value of your portfolio.
Apart from protecting your portfolio from going down, hedging would also help reduce the volatility of your portfolio. Hedging reduces the beta of the portfolio in uncertain times, i.e. the volatility of the portfolio decreases in turn making the value of the portfolio steady and stable. If done properly over a long haul then a hedged portfolio can give better returns than an un-hedged portfolio.
When to hedge
It is advisable to hedge only when you think that stocks in your portfolio would experience volatility in the next couple of months and the long term outlook for the stocks are still strong. The fundamentals of the stock should remain sound. If you think the fundamentals are not great and the fall would be deep, it is better to sell the stocks rather than hedge the fall.
It is advisable to hedge your portfolio through options if implied volatility is less and time left to expiry is also high, this would mean that you are insuring your portfolio in cost effective way and for longer duration.
Implied volatility is the estimated volatility of the stock. This would increase in a bearish market and decrease in a bullish market, as bearish market is riskier. Hedging can be done using stock options as well as index options.
Using stock options
The most popular strategy is to buy put options to hedge a portfolio. In times of uncertainty, investors could buy put options to protect erosion of significant portfolio value. This strategy is also known as ‘protective put’. This is especially useful when you want to protect gains made on your stocks (which you are holding for the long term) and the near term outlook for the stock is uncertain.
Under the strategy, you need to buy a put option taking the current market price of the stock as the strike price. Any downside in the stock would be offset by gains in the put option. This is because put option becomes valuable when market price of the stock falls below the strike price of the put. Another advantage is that the maximum loss from the strategy is limited to the premium paid.
Some other strategies that you could use for near term uncertainties in the stock are:
• Covered calls – By selling call options, you can hedge against a small drop in any stock in your portfolio. When the stock price drops, the premium received on the call would help cover up the loss you might have incurred. The covered call strategy would protect the portfolio only to the extent of premium earned. Any sharp fall in prices may not be fully protected under covered call writing.
• Call collar – Under this strategy, you buy put options while simultaneously selling call options. This strategy would protect you from downside while simultaneously increasing the profitability from any upside in the stock. It is important that both the put and the call options are ‘out of the money’ (OTM).
Here’s an example. You are holding HDFC Bank which was trading at Rs 1230 in the mid of October. You decide to establish a collar by writing an October 1240 call for Rs 15 while simultaneously purchasing a November 1220 put for Rs 5. The total investment would be Rs 10 (Rs 15- Rs 5).
What happens when the stock price goes down to Rs 1210? The call option you sold would expire worthless while the put option would have an intrinsic value of Rs 5. Your total profits from hedging would be Rs 10 (initial investment) plus Rs 5 = Rs.15. So, the loss due to the fall in the stock would be limited to Rs 5. If you hadn’t hedged, the loss would have been Rs 20. If the stock remains at Rs 1230, you would have still gained Rs 10 from the strategy.
Using index options
Use index options for hedging only when you have too many different types of stocks in your portfolio. You could choose index options in case there is a big event which may alter the course of the market.
Index options are better than using stock options as they have greater liquidity. Impact cost will be less as compared to stock options. Index hedging would also help protect your portfolio from other adverse economic conditions like high inflation and interest rate changes that affect the market.
Steps in hedging
• Identify the index that closely resembles your portfolio. Doing a correlation might help.
• Decide whether you are going for a partial or full hedge.
• Ascertain the possible market condition that might prevail during or by the end of the options period
• Choose the strategy based on the ascertained market condition.
• Find out the cost of the hedge strategy and ensure that it is worth hedging.
Points to note
It is very important to remember that hedging involves cost. You should see if this cost is worth the uncertainty that you think the stock will affect the stock. The hedging cost should not exceed 5- 7 per cent of the portfolio value. You need to be certain that the change would be big enough to warrant your hedge. You should keep in mind the premium being paid for the options and the duration until which you want to keep the hedge to reduce costs. Also, remember that you are hedging to protect your portfolio, so don’t book profits and lose the hedge.
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Disclaimer: Views expressed here in this article are for general information and reading purposes only. They do not constitute any guidelines or recommendations on any course of action to be followed by the reader. The views are not meant to serve as a professional guide/investment advice / intended to be an offer or solicitation for the purchase or sale of any mutual fund or stock.