Skill Sheet: What You Will Learn Here
- What is hedging in trading?
- How hedging works
- Learn how to hedge using futures
- Speculation vs hedging
Let's begin by understanding what is hedging in trading. Hedging in trading is a risk mitigation strategy which allows traders and investors to reduce the risk of their investments. This strategy involves taking an opposite position in a related asset.
Some of the instruments used for hedging include futures, forwards and options. Let's see an example to understand how you can use futures for hedging.
Suppose you hold 100 equity shares of ABC Ltd, which are currently trading at Rs 100 a share. You have a long-term view of the stock and expect it to give good returns over the next few years. However, the CEO of ABC Ltd is expected to retire in the next two months. As a result of the change in management, you expect the stock of ABC Ltd to correct in the short term. However, this doesn't change your view on ABC Ltd, and you want to continue holding your position given its long-term prospects.
One way to protect your downside risk in this situation is by selling the futures contract of ABC Ltd in the futures market. This is essentially called hedging in futures.
To keep things simple, let's assume 1 lot of ABC Ltd comprises 100 stocks. And you were able to sell 1 lot of ABC in the futures market at a price of Rs 100. Note that this is a perfect hedge. More often than not, you will not be able to hedge a position perfectly. We have simplified this example just to help build your understanding.
Now, note that by selling the futures contract, you have a simultaneous long and short position on ABC Ltd.
Now, let's assume the stock of ABC Ltd falls as per your expectations and is now trading at Rs 90. Under this scenario, your cash position will decline by Rs 10,000 (10 x 100 shares). However, your futures position will increase by Rs 10,000. This means all the losses of the cash segment were offset by the gains in the futures segment. In this trade, all you will lose is the transaction of selling futures of ABC Ltd.
But what if the stock of ABC Ltd doesn't fall and instead rises to Rs 110?
Under this scenario, you will profit from your original position, but your losses in the futures segment will eat away all your gains.