Role of futures market is humongous in hedging, speculating, and for arbitrage opportunities. All of us who invest in stock market are concerned about the volatility in the short term. Sometimes despite knowing for reasonable certainty that market will go down, we find ourselves helpless to do anything as the fluctuation is thought to be only temporary. Futures can help us in handling such situations and hedge the risk of losing the value of our portfolio.
How to use Futures Strategies:
Before we begin to discuss the strategies, we should remember that the purpose of hedging is to save us from losing money. Hence hedging will help us when the market goes down but at the same time, the investors will not be able to reap the benefits when the market goes up. It is important to realise the goal of hedging. Now that we know what hedging means, let’s look at few strategies that can be used to preserve our capital and hedge the losses.
We will consider a scenario. You have a portfolio and you want to hedge the portfolio risk.
The concept of hedging is simple. Take the opposite position of cash in futures and your potential loss can be hedged.
Let’s do it with an example.
Hedging Portfolio using Index Futures:
Let’s say an investor has a portfolio of stocks and he anticipates that the market price of a majority of stocks in his portfolio may go down in near future. He is worried that this will wipe out the gain he made in last couple of months.
What can he do?
The investor can use index futures to hedge against any possible loss. Take an example.
An investor RJ has a portfolio worth 10 Lakhs. The beta of the portfolio is 0.98. Beta of a stock or a portfolio is defined as the relation of its returns with that of the market. A beta of 1 means, the stock or portfolio goes up and down in the same rate. In our case, beta of 0.98 shows that the value of portfolio will go up or down with market by a multiple of 0.98. This means if the market goes up by 10%, our portfolio goes up by 9.8%; similarly in case the market goes down.
To completely hedge this position, RJ has to take a short position in index futures worth beta*portfolio value = 0.98*10 Lakhs = 9.8 lakhs. Let’s say, Nifty future is quoting at 5100 for 1 month futures. Let’s assume that each Nifty contract is 200 units. Hence one contract will be equivalent to 200*5100 = 1020000. Ideally, RJ would like to sell Nifty contract worth 9.8 lakhs but it is not possible because the lot size is fixed. This means to hedge the portfolio, RJ has to sell (short) a minimum of 1 contract of Nifty. Now let’s take two scenarios.
| Initial Value | Final Value (in 1 month) | Gain/Loss | ||||
| Portfolio Value | Nifty Futures | Portfolio Value | Nifty Futures | Portfolio | Nifty Futures | |
| Market down by 10% | 10,00,000 | 10,20,000 | 9,02,000 | 918000 | -98,000 | 1,02,000 |
| Market up by 10% | 10,00,000 | 10,20,000 | 1098000 | 1122000 | 98,000 | -1,02,000 |
Calculation steps:
If the market goes down by 10%, the value of nifty contracts will come from 10,20,000 to 10,20,000*0.9 = 9,18,000
However, the value of portfolio will be down by 10%*0.98 = 9.8% only. Hence the value of portfolio will be 10,00,000*0.902 = 9,02,000. Similarly, you can calculate when the market goes up.
| Overall Payoff when Market goes down by 10% = | 4,000 (1.2L-98K) |
| Overall Payoff when Market goes up by 10% = | -4,000 (98K-1.2L) |
As shown above, we have taken two scenarios. In first scenario, the market goes down by 10% and in the second, the market goes up by 10%. In the first scenario when the market is down by 10%, RJ has been able to hedge the risk as his portfolio did not go down by 10%. In the second scenario, even though the market has gone up by 10%, RJ has not been able to take advantage of the growth because of hedging.
This implies that hedging is used primarily to hedge the risk of loss. It doesn’t generate profit when your assessment goes wrong.
The second conclusion we can draw is that hedging is not 100%. You cannot hedge your complete portfolio because of simple reason that the exact value of holding will not match the value of contracts you can buy. You can buy index futures in the given lot sizes only and this may not match with your portfolio value.
You can also partially hedge your portfolio. For example, if you have to hedge only 50% of your portfolio, sell the futures worth close to 5 lakhs (50% of the portfolio).
Pankaj Priyadarshi
Pankaj Priyadarshi is an author at Lastbull.com. He has 11 years of international and domestic experience in the areas of Finance, Management, and Business Analysis in the USA and India.He is a co-founder of 'Vertical Grass', a consulting initiative in the area of finance. A Graduate from IIT(Engineering) and ISB(Management).
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