The importance of hedging in trading

Hedging is an important tool to protect your portfolio against the vagaries and volatility of the stock markets. Similar to an insurance cover, hedging secures your investment from the risk of potential losses. For example, health is one of our greatest assets. If we do not insure our health, there is a significant probability of losses in case of a medical emergency, both from the perspective of treatment costs and a loss of income due to illness.

Thus, health insurance safeguards the insured against possible unfavourable events in the future.

In the financial world, most traders and investors deploy a hedging strategy to mitigate risk after taking a position in the Futures and Options market. When you’re bullish (that’s when you feel the price of a derivative will rise), you go long on a future and simultaneously buy a ‘PUT’ option to hedge your position. The ‘PUT’ option allows traders to profit from a stock’s decline, thereby minimising the magnitude of losses, in case the price falls before the option expires.

In contrast, when you’re bearish (that’s  when you feel the price of a derivative will fall), you go ‘SHORT’ on a future and simultaneously buy a ‘CALL’ option to hedge your position. It must be noted, that hedging does not entirely eliminate losses, it just diminishes the overall negative impact.

Let’s make this clearer.

Nifty50 closed at 17,616 on February 1, 2023. Suppose, you want to take a long position on Nifty50 futures at 17,700 because you expect the benchmark index to grow and touch the expected level at the time of expiry.

In order to hedge your position, you will buy a ‘PUT’ at a lower strike rate, which is nearer to the entry point, say 17,600 or at least a strike away, which is 17,500. Now, if Nifty50 rises, the potential of your maximum profit is unlimited in the payoff chart.

However, if Nifty50 moves in the opposite direction, your maximum loss will be limited at the time of expiry, as you have already hedged your position.

Now, let’s check out a contrasting trading scenario.

Say, you want to short an Adani Green share at Rs. 1,100. Adani Green closed at Rs. 1,160 per share as on February 1^st. So, for hedging, you will concurrently buy a ‘CALL’ at a higher strike rate near your entry point – say Rs. 1,200 or one strike away, which is Rs. 1,300. By doing so, you’re putting a cap on your maximum loss by hedging, even if the share price swings in the direction opposite to your original short position.

Besides using hedging in derivatives, you can use a similar approach across all asset classes, such as equities, commodities, currencies, and even interest rates and the weather.

For example, if – as a result of continuous interest rate hikes – the stock market starts shedding points and is no longer giving you inflation-beating returns,  you can look at gold as a hedging option. Since gold prices are usually inversely related to the stock market, investors tend to park their money in the precious metal when the bourses are bleeding.

Also, when you hedge your position, you are aware of the maximum loss you may incur in case things go south. This knowledge grants you a fair idea of whether to enter a trade based on your risk appetite and loss capacity. Thus, hedging not only helps you cut losses in adverse scenarios, it also enables you in making sound trading decisions.

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