Everything about Hedging
One of the most practical and essential uses of Futures is hedging. In a situation where market movements are unfavourable, hedging offers a way to guard against losses for your trading position. To offer an example, let me try explaining what hedging really is.
Seeing an opportunity, you decide to transform the barren land right outside your house into a flourishing garden. You put in efforts to water and nurture it regularly and after some hard work, your little plot of land grows lush and the flowers bloom. Unfortunately, along with admiration, your garden starts to attract attention from some local cows which are grazing away your grass and trampling on your flowers. In order to take control of the situation, you come up with a simple solution – build a fence or a wooden hedge around the garden. This plan not only defends your flowers from marauding animals but also helps it flourish further!
We can now link this comparison to the markets –
I hope the analogy above gave you a better understanding of ‘hedging’. As earlier mentioned, it is a strategy to protect your market position against potentially unfavorable movements. Do not be mistaken however; hedging can secure individual stocks as well, although with some limitations.
– Hedge – But why?
This is a question that comes up often in debates about hedging: What is the purpose of it? Think about this scenario: An investor buys a stock for Rs. 100 and assumes the market will go downward, which will cause their stock to decrease in value. They can choose from two options: one, they can sell their stock or, two, they can hedge their position by purchasing contracts to reduce potential losses.
Let us consider an unfettered market situation when a trader invests in a stock that drops from Rs.100 to Rs.75. Over time, it is predicted to bounce back up to its original value. In this case, what would be the benefit of hedging?
It is clear that when a stock drops from Rs.100/- to Rs.75/-, that is a decrease of 25%. To move back to the original investment value, however, the stock would have to go up 33.33%. In other words, it takes less effort for the stock to go down than it does for it to go up. From my experience, I can tell you stocks do not usually rise substantially unless there is a bullish market. Therefore, it’s wise to hedge your positions in anticipation of a major decline in prices.
The second option, of selling the position and buying back at a later stage, presents a challenge in timing the market and consequently, the trader will miss out on Long term capital tax benefits. Additionally, frequent transactions attract transactional fees.
Given the range of benefits provided by hedging, it makes sense for this trader to apply it to his position: he’ll be effectively ‘insulated’ from market movements and able to rest easy, just like after taking an immunization.
Before we move on to comprehend how we can guard our positions in the market, it is essential to comprehend what kind of risk we are aiming to protect ourselves against. Clearly, as one may expect, we are attempting to hedge the danger.
When you purchase stock of a company, you are highly likely to face some form of risk. These risks can generally be divided into two categories – Systematic Risk and Unsystematic Risk. Anytime you buy a stock or stock future, you become subject to both of these types of risks.
The stock market is unpredictable, and many variables can cause the stock price to fall. The stock can experience losses due to a variety of factors, including market conditions, economic downturns, and bad news about the company whose stock you’ve invested in.
It is noticeable that all of these potential risks are company-specific. As an illustration, let us say you have invested Rs.100,000/- in HCL Technologies Limited. When the firm reveals its revenues have dropped, it follows that their stocks will also decrease – leading to a loss on your investment. On the other hand, this news would not affect the stock price of competing companies such as Tech Mahindra or Mindtree. In such cases, it is only the company itself that is exposed to this kind of risk which can be considered “Unsystematic Risk”.
Investing in a diversified portfolio is a great way to mitigate unsystematic risk. Rather than investing all the money in one company, it is advisable to choose two to three different companies from different sectors. Suppose half of your capital was invested into HCL and the other half was invested into Karnataka Bank Limited; if the stock price of HCL declined due to unsystematic risk, only half of your investment would be affected. You can raise the number of stocks in your portfolio further, with more diversification meaning less unsystematic risk.
This raises the question of how many stocks a well-rounded portfolio should possess for the purpose of full diversification. Research has determined that a maximum of twenty-one shares is sufficient to obtain the required scattering, while any quantities beyond this likely offer only minor additional benefit.
The graph above clearly shows how diversification works to reduce unsystematic risk. After a certain point, which appears to be around 20 stocks, the graph begins to flatten out indicating that the unsystematic risk is no longer able to be fully mitigated. What remains of this risk is called ‘Systematic Risk’.
Systematic risk is the type of risk that applies to all stocks, usually those macroeconomic risks which have an effect on the entire market. Examples include things such as political instability, natural disasters and fluctuations in interest rates.
The list of components that make up systematic risk could be expanded further. But you should have an understanding, now, of what it entails. All stocks are subjected to this type of risk; given the example of a portfolio consisting of 20 stocks, if there is a decrease in GDP, they will all likely decline. Because such risk is inherent to the system, it cannot be diversified away; though it can be hedged against. It important to note that hedging and diversifying are different techniques.
We should diversify our investments so as to reduce unsystematic risk, and hedge them to counterbalance systematic risk.