Hedging with Futures – Process, Examples, Benefits, Risks & more

Learn about Hedging with Futures in the Futures Market.

Hedging is an important concept in the context of futures. But do you know why it is important to understand everything about hedging?

In the event that the market events do not turn out as per your expectation, you will need to employ hedging as a technique to stop yourself from making a loss.

About Hedging with Futures

Hedging in Futures works like a balancing act, if anything goes wrong in the futures investment process. It helps in mitigating losses or making more profits.

In the stocks markets, you may perform your estimates and judgements with all the care in the world.

Eventually, you will come to save a sizeable amount of your money in the form of stocks in the spot and futures market.

However, the events which take place in the market are not tuned to your expectations. Any number of factors can move the markets downhill and expose your portfolio to the possibility of incurring losses.

So, this factor calls for a need to protect your portfolio, which is what hedging is all about.

Thus, we can conclude that hedging is a technique which shields your position from the adverse elements of the market.

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Why do you need to Hedge your market position?

Even for someone who is trading dormant in the market, there may be some motivation to understand exactly why hedging is important. So, consider that a trader has an investment of INR 1000 in the market.

But after purchasing the stock, the market situation changes and a sudden downfall in the value of the investment may take place. Thus, in a situation like this, the trader has one out of three options.

They may do nothing and wait for the stock price to bounce back up later. Or they may sell the stock now and buy it again when the price is low or else, they can hedge the exposed position.

Now, if the trader decides not to hedge their position, they will pick either of the two options above.

Though, waiting for security to bounce back up may not be a wise decision. Unless there is a bullish push in the market, the chances of a security going back to its original price are slime.

Choosing the second option would mean dissolving the capital and it will also entail additional transaction costs.

This is the fair reason why hedging is widely encouraged while taking a position in the stock market.

Hence, hedging with futures is like insulation against the adverse conditions of the market and its forces, which protects your futures investments from diminishing in value.

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What is the risk involved in the markets?

Before understanding anything about actually hedging a market position, it is vital to understand the motive behind it. So, what is this risk that we are trying to hedge against?

By purchasing any futures contract, you are opening yourself to the possibility of two types of risks and these are systematic and unsystematic risks. There are an endless number of reasons why the value of a futures may decline in the market.

It could be due to declining revenues, poor profit margins, high leverage, growing financing costs, misconduct from the management and more.

These and many other factors pose a serious risk to the position of the trader. It is worthy to notice at this point that each of these risks appear to be specific to the company only.

Come to think of it! If news of any of these factors about a company were to spread in the market, what would be its result?

Naturally, it would come to affect the price of their futures contract adversely. If you notice, these factors are central to the company alone and not representative of the whole market. This is why such risks are called ‘unsystematic risks’.

Now, as far as hedging goes, there is a simple way to limit the unsystematic risk which you expose yourself to.

Instead of putting all your money on one futures alone, you can pick out more than one futures contracts for investment.

When done across a variety of sectors, you will take a more diversified position than investing only in one stock.

Example on Hedging with Futures

So let us take an example to demonstrate how such diversification can take place.

Suppose you have INR 100 to invest in futures. Now, instead of putting all your money in future contract such as Bank of Baroda, which represents the banking sector, why not divide this money into three parts?

In doing so, you will be able to invest your money in three different stocks. Then, you can pick three promising future contracts, but from different sectors.

This can include any of the leading industry sectors in the country such as automobiles, electronics, manufacturing, sugar etc.

So, even if tomorrow a negative piece of news was to emerge that would impact the futures price of Bank of Baroda, your portfolio will still be under a shield since you did not put all your eggs in one basket.

This is just a hypothetical example and in reality, investors go on to choose up to 10 and more sectors to invest in. The more the diversification, the lower is the incidence of unsystematic risk.

There is promising research to indicate that having up to 10 futures contract in a portfolio makes it a diversified one.

Adding more futures contract to your portfolio drastically reduces the unsystematic risk which you may face if such diversification was absent.

However, even after diversification of the portfolio, an investor continues to remain exposed to systematic risk. Systematic risks include factors which have an impact on almost all futures.

These can be tightening of interest rates, rising inflation, changes in the political scenario, the impact of relations with other countries and more.

But, as you may have already guessed, diversification is not the way to protect yourself from such risk.

Thus, if any adversity in these factors occurs, it is likely that all futures contract in your portfolio will fall. This is where the role of hedging comes.

How to Hedge a single stock?

Let us take an example to understand the concept.

Let us assume that you have with your 250 stocks of ABC for INR 2284 each and the total value of such investment will be INR 571000. This is a long position in the spot market.

Now, due to your estimates, you have a feeling that the stock price may fall down in the days to come.

This is where you can ‘hedge’ your position to avoid making a loss from such a fall. Hedging involves taking a counter position opposing your current position.

So, to counter your current position, you will have to go short in the futures market. Let us assume that the following are the details of the trade:

ABC futures: INR 2285

Lot size: 250

Value of contract: INR 571250

Now, you have two positions in the market. One is a long position in stock ABC in the spot market. The other is a short position in ABC in the futures market. This will make your position hedged in the market.

No matter where the price of the security heads, you will neither make a profit not incur a loss.

The resulting profit and loss from these positions will be the same as long as the number of shares in both cases are the same.

The following table illustrates how this will happen:

The concept of Beta in Hedging with Futures

The concept of Beta is very important in the world of finance. It is a Greek symbol which is denoted as ‘β’. The concept of beta is crucial to the complete understanding of hedging.

Beta is a measure of the Futures price sensitivity which occurs due to changes in the market. Β can be higher or lower than zero but for market indices like Sensex and Nifty, it is always + 1.

Let us say that the Beta of Futures Contract ABC is + 0.7. This would imply the following matters:

• With every + 1 % increase that happens in the market, the futures ABC will most likely move by 0.7 %. The reverse is also true for the same proportion.
• Since the beta of ABC is less by 0.3 % from the market beta, ABC is 30% less risky than the markets. Thus, the level of systematic risk associated with ABC is less in comparison to the markets.

In general, Beta says a lot about the risk associated with a futures contract. Here are some fair and common points which highlight what beta represents about a future contract.

Less than 0 (zero):

If the beta of a future contract is negative, it means that the futures price and the markets move in opposite directions to each other.

Equal to 0 (zero):

Although rare, it would mean that the movement of the market does not impact the price of the future contract.

Less than 1 (one) but more than 0 (zero):

This is the case of a low beta future contract which happens to be less risky in the context of the market. Any change in the market will bring a change in such contract in the same direction but less quantum.

Higher than 1 (one):

These are high beta future contracts and move in the same direction as the market but a change in the market tends to bring a greater impact on such contracts, making them move by a larger quantum.

How to Hedge a Portfolio?

In order to cover both, systematic and unsystematic risks, using an Index future is the best way. Using an index future helps to diversify the stocks and generally cushions the impact of a market turmoil.

Let us take an example to understand the concept of beta and hedging.

At the first step, we will calculate the portfolio beta. It is the sum of the weighted beta of each stock. To calculate the weighted beta, the total investment is divided by the investment in a particular stock.

So here’s how the calculation will be done for the above data:

Here, the sum of the weighted beta is what we call the portfolio beta. In this case, it is 1.223.

Since it is positive, the market and the portfolio will move in the same direction. But for every 1% move that the market makes, the portfolio will move by 1.223%.

This brings us to the second step of our calculation, which is to calculate the hedge value. It is the product of the portfolio beta with the investment value.

In this case, it would mean 1.223 * 800000. This will be equal to 978400. Since this is a long portfolio in the spot market, it will be hedge by taking a short position in the futures market.

In the next step, we will calculate the number of lots which will be needed to hedge the position. Let us say that the Nifty index is trading at 9025 at present for a lot size of 25. The total value of the Nifty will be 225625.

Therefore, the number of lots needed to hedge the position =

978400 / 225625 = 4.33.

Thus, in order to hedge the position, we will need to short at least 5 lots of Nifty futures to properly hedge the position.

To Conclude Futures Hedging

Hedging is a way to insulate your market position against the adverse movements of the market.

The calculation of beta helps an investor estimate how they can insulate or hedge their position in the market.

It is not easy to construct an exact hedge and this is why your position may be over hedged or under hedged.

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