Hedging Strategies Explained: Protecting Your Portfolio Like a Pro
Amidst prominent growth trends, the retail participation in Indian markets has been at a steady high, as direct and indirect retail holdings grew over 10 times in ten years1. However, market investing often fuels nervousness among investors due to volatility risks.
However, downturns are part and parcel of market investing, just like illness is typical to any living being. Subsequently, like a health insurance provides cover against illness costs, hedging strategies can act as a financial insurance against market risk. Understanding hedging in investing, through its common tools and strategies, can help portfolio optimisation and capital preservation during unstable markets.
Common Hedging Tools
A risk management portfolio strategy that allows investors to minimise the impact of adverse market events by investing in opposing assets and positions is called hedging. It is like ordering two desserts. In case you don’t like one, you would have the other to compensate.
Some popular stock market hedging techniques and tools that can also protect anticipated losses from other market-linked securities are discussed below.
1. Futures
A legally binding standardised contract that mandates the purchase and sale of an underlying asset at a predetermined date and rate is called a Futures contract. It provides cover against downside risk by ensuring a predetermined rate. Let us understand futures hedging through an illustration.
Suppose Mr A holds 100 shares of XYZ Ltd., currently trading at INR 1,500 each. However, he expects the price of shares to fall next month and wants to hedge against that risk.
Therefore, Mr A decided to sell one future contract (100 shares) at INR 1,500 with one-month maturity. Mr B, who anticipates a price rise, buys the contract. When the contract automatically settles after a month, the following scenarios can occur.
| XYZ share price falls to INR 1,300 (Assume) | ||
| Particulars | One share (INR) | Total (x100) (INR) |
| Current share price | 1,300 | 1,30,000 |
| Futures price | 1,500 | 1,50,000 |
| Profit | 200 | 20,000 |
| XYZ share price rises to INR 1,600 (Assume) | ||
| Current share price | 1,600 | 1,60,000 |
| Futures price | 1,500 | 1,50,000 |
| Profit opportunity missed | 100 | 10,000 |
Future hedging risks the potential profit to avoid potential loss. If the share price rises over the future contract price, the investor (Mr A) does not lose funds; he simply missed the opportunity to make a profit. However, if the price fell as anticipated by him, he would have avoided actual loss.
2. Options
An option contract gives its holder the right, but not an obligation, to buy or sell an underlying asset at a predetermined rate within a specified tenure. The illustration below helps explain the options hedging strategies.
Imagine Mr A holds 100 shares of XYZ Ltd., currently trading at INR 1,500 each. However, this time he anticipates a price fall, but he is not certain. Therefore, he does not want to compulsorily liquidate, like in the case of futures.
Therefore, he can buy one put option on XYZ shares, with a strike price of INR 1,500 each. He has to pay a premium of INR 10 each. Discussed below are possible scenarios.
| XYZ share price falls to INR 1,400 (Assume) | ||
| Particulars | One share (INR) | Total (x100) (INR) |
| A. Current share price | 1,400 | 1,40,000 |
| Without the options, A would have lost INR 10,000 when the price fell from INR 1,500 to INR 1,400. | ||
| B. Options price | 1,500 | 1,50,000 |
| C. Premium | 10 | 1,000 |
| D. Gain on options (A-B) | 100 | 10,000 |
| E. Net Gain (D-C) | 90 | 9000 |
| XYZ share price rises to INR 1,600 (Assume) | ||
| A. Gain (1,600-1,500) | 100 | 10,000 |
| Mr A will ideally choose not to exercise the option. In this case, he would lose INR 1,000 (premium) only. | ||
If futures and the protective puts strategy seem complicated to some investors, they can utilise fixed-income securities and gold as portfolio protection in India.
3. Gold and Fixed-Income Securities
Due to its intrinsic value, gold as a macro-hedge has historically recorded growth during inflation and market downturns. When assets like stocks turn red, gold acts as a safe-haven investment, ensuring capital preservation and appreciation. For instance, during the 2008 financial crisis, gold prices increased dramatically, as they recorded a 101.1% rise in the Producer Price Index (PPI) between 2008 and 20122.
Similarly, the fixed-income securities like bonds and fixed deposits provide predictable returns, minimising portfolio risk, and thereby controlling loss during downturns.
Gold and fixed-income securities are common hedging strategies in India. Therefore, a real-life simulation of using these tools can optimise investing.
Real-Life Examples Of Hedging
Discussed below are some real-life sample illustrations to analyse how gold and fixed-income securities act as a hedge.
1. Gold: Hedging with Derivatives India
When inflation increases, the price of commodities increases and the purchasing power of money falls. Subsequently, the price of gold also increases when inflation rises. For instance, in 2010, Mr A bought gold for INR 50,000 and kept another INR 50,000 in cash. By 2025, the gold value rose to INR 70,000. However, the cash was still INR 50,000 and worth much less because prices had gone up.
2. Hedge Using Bonds
Just like gold aids currency hedging in India, bonds can also help cushion against equity market downturns. For instance, if A makes a loss of INR 5000 in the equity market but earns INR 3,000 bond interest, their effective loss is reduced to INR 2,000.
Conclusion: Hedging For Retail Investors Made Simple
Optimal hedging strategies stem from diversification of funds across different asset categories. The objective is to set off losses on one asset class with profits from another. Fixed-income securities like bonds offer passive income and hedging opportunities.
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FAQs On Hedging Strategies
1. What is the simplest hedging method?
The suitability of a hedging method depends on investor needs and temperament. However, fixed-income securities, like bonds, can serve as an optimal risk-averse strategy for investors.
2. Can small investors use hedging strategies?
Yes, small investors can use hedging strategies based on their investible funds. Investment in assets like bonds and debt funds can begin with limited funds.
3. Is gold a good hedge?
Gold has historically acted as a safe-haven investment during financial turmoil and inflation due to its high intrinsic value.
References:
1. Money control, accessed from: https://www.moneycontrol.com/news/business/markets/retail-power-retail-holdings-rise-more-than-10x-over-the-last-decade-12901840.html
2. BLS, accessed from: https://www.bls.gov/opub/btn/volume-2/pdf/gold-prices-during-and-after-the-great-recession.pdf
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