| Demystifying Derivatives – Series V |
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So far in the series we have covered the following:
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Series I - What are derivatives, futures and an example on how futures work? |
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Series II – What is protective put and how does it work? |
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Series III – What are options and how they work? |
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Series IV - What is covered call? |
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In this final note of the series we would cover how can one use combination of futures and options to do some hedging? |
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How to do simple hedging? |
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In case of a simple hedging, one can buy a stock future with high beta and correspondingly sell Nifty future (for broadly similar value). The basic nature of this strategy is to limit your losses in case of a fall in market, i.e. to minimise losses.
Benefits of hedging are:
- Reduces your loss in case of fall in stock price
- Helps generate better returns in case of volatile markets
- No need to time the market and one can stay invested for longer
How does simple hedging work – an example
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Say Bharti Airtel Ltd. trades at Rs 1000 today and you expect it will touch Rs 1200 in one month but you are worried that market is quite volatile and could fall as well but you are convinced with the overall fundamentals of Bharti – what would you do?
- Buy one stock futures lot of Bharti Airtel and correspondingly sell one lot of Nifty Futures (assumed that the value of one lot would be similar although practically that may not be the case)
- It is assumed here that Bharti has a Beta of >1
- Beta of >1 would mean that Bharti would appreciate / depreciate higher compared to overall Nifty sensex.
- By doing this you reduce your loss in case market falls compared to only long position in stock futures i.e. you received the money for selling Nifty future which will partially compensate for the loss on Bharti Airtel.
- In case the price increases you make a loss on Nifty futures position but you make higher profits on Bharti Airtel – although in this case the profits would be lesser compared to only long position in stock futures.
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To summarise, in case of hedged position, losses as well as profits are lesser compared to plain long / short position in stock futures.
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