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Hedging in Stock Market Explained
Traders in the stock market have different objectives. Some of the most important objectives are making profits in the long term, getting frequent gains in the short term, and protecting your investments in the stocks from extensive losses in the future.
Published on 20 February 2023
Hedging is a financial tool that helps you achieve the third objective. It is a risk management strategy that reduces the effect of uncertainties on your investments. In a way, it restricts the losses that result from fluctuating price movements of the stock.
Let us get into the details for a better understanding on hedging in the stock market.
What is Hedging?
Hedging can be defined as a financial tool which is a risk management strategy that you can utilise to offset losses in your current asset by taking a position in a related asset. The additional position provides a compensating gain when the actual position starts making a loss.
Two important pointers in hedging:
- Hedging comes at a premium cost.
- Hedge can help you prevent future damage but cannot erase or undo the previous damage.
Hedging is predominantly employed by the Indian equity and futures and options participants.
Let us consider a simple example.
Ram decides to buy a particular stock. He expects the stock price to rise and wants to take a position to reduce the loss in case the prices fall.
He can hedge that risk by engaging in a put option. He can purchase a put option at a cost that will give him the right to sell the stock at the same price. Then, if the stock price falls, he can exercise the put option to get back the money he had invested, subtracting the cost of the purchased put option.
What Is a Commercial Hedger?
A commercial hedger is a producer or company of a product that utilizes the derivatives markets to hedge. They can hedge their market exposure to the items they produce, or the inputs required for the items they produce. For instance, a clothing company uses cotton to make its clothes. Therefore, they might buy cotton futures for hedging shares against the rising cotton prices. Similarly, a cotton farmer might sell cotton futures to hedge against the dropping prices in the market before the harvest season.
What Is De-Hedging?
De-hedging refers to closing out a present hedge position. You can go for it when a particular hedge is no longer required. Sometimes, de-hedging is done because the price of the hedge has become expensive. Furthermore, it is also done when investors intend to benefit from the additional risk of an unhedged position.
Types of Hedging
Hedging as a risk management tool is utilised in the following areas:
- Commodities that include agricultural products, metals, etc.,
- Securities that include shares, equities, etc.,
- Currencies that include various foreign currencies that might get affected due to volatility or currency risk.
- Interest rates include lending and borrowing rates.
Hedging can be exercised in the derivative market that includes the forward contract, futures contract, etc., and the money market that involves short-term buying and selling, lending, borrowing, etc.
How Can Hedging be Exercised in the Stock Market?
The put option that we had discussed earlier will rise in value if the stock you have purchased falls in price. And if the value of the underlying asset rises, the put option will fall in value. The maximum loss, in any case, is the amount spent on purchasing the put option. And, the premium will certainly be a small portion of the purchased stock.
Hedging in the share market to minise risk can happen at three different stages.
1. At the time of purchasing the stock
When you are skeptical of purchasing a stock, you can initiate the trade with a hedge. In such cases, with the confidence of facing a downside by the offsetting position of the purchased hedge, you can buy the stock with satisfaction.
2. After purchasing the stock
You have purchased a stock and find the prices tend to fall. In such cases, you can utilise the hedging strategy as you near the stop loss level, beyond which you cannot afford to lose any amount by purchasing a put option at a premium.
3. When the purchased stock makes a profit
You have purchased a stock and find the prices keep increasing. Immediately, you tend to be skeptical whether to sell the stock at the current price and book the profit or hold it for a while to further the gains. In such cases, you can buy a put option and lock the profit with a hedging strategy.
Advantages of Hedging
Hedging can be a beneficial tool considering the following advantages.
- A hedge can protect your capital from adverse events that lead to extreme losses. For example, a black swan event can cause massive destruction to the financial markets. With a hedging strategy employed smartly, you can prevent such events from causing excessive damage to your investments.
- Traders having a low-risk appetite can trade in the stock market using the hedging tool and stay at peace.
- Helps traders diversify the portfolio, increasing liquidity.
- Saves time required to keep monitoring the prices.
Also Read: Portfolio Investment
Disadvantages of Hedging
While hedging can protect you from potential risks, it has to be exercised with caution.
- Hedging can drag your profits if it is bound to occur. If you lock your profit at a certain point and the prices go up further, you lose the actual profit.
- The purchase of the stock and the hedge have transaction costs. If you have not done effective research on the cost of purchasing in detail, you might incur high transaction costs.
How Is Delta Used in Hedging Options Trades?
Delta refers to a risk measure applicable to options trading. It reveals to what extent the price of the option will change, considering a $1 shift in the underlying security. When you purchase a call option with a 30 delta, the price will differ by $0.30 when the underlying security moves by $1.
When you intend to hedge such a directional risk, you can sell 30 shares and become delta neutral. Therefore, delta can also be considered the ratio of an option for hedging in the stock market.
How Can a Protective Put Hedge Downside Losses?
A protective put revolves around purchasing a downside put option. In a downward put option, the strike price is lower than the present price of the underlying asset in the market. The put provides you with the right to sell an underlying stock at the strike price before it gets expired. However, it’s not mandatory for you to sell the underlying stock.
Suppose you own an XYZ stock from $100, and you wish to opt for hedging stocks at a loss of 10%. In that case, you can purchase the 90-strike put. It will ensure that even if the stock drops to the lowest price, you will still be able to sell your stock at a higher price.
Example of a Forward Hedge
When we talk about finance and stocks, hedging in the stock market comes as an important topic. Take this example for instance. There’s a manufacturing unit that deals with product supplies both in the local as well as overseas markets. So, it’s understood that the organization is involved in both exports as well as internal trade.
Now, in such a situation if the company earns around 80% of its revenue from overseas trade, it will try to protect this income. However, at times the foreign currency exchange rates keep on fluctuating and that could cause either loss or profits.
In case it is a potential loss, here are some ways the organization will plan to stop it.
- Set up internal manufacturing units at foreign locations. This way, potential losses arising out of currency fluctuations can stop.
- Sign a contract with customers urging them to pay in the organization’s home currency.
This is one of the examples that we can put forward to elucidate the topic of hedging.
Conclusion
Hedging is a financial tool that helps you reduce losses due to unexpected events in the stock market. It is an effective risk management tool that comes at a premium cost. You can utilise it while initiating the trade, after purchasing the stock to protect it from losses or after the profits start incurring to lock it after a certain extent. Research the different options and use the hedging tool to minimise risk effectively!
