Hedging a single stock position
We will first discuss hedging a single stock future, as it is straightforward to put into action. Its limitations should then be acknowledged before delving into the process of hedging a portfolio of stocks.
By purchasing 250 shares of Infosys at Rs.2,284/- per share, you have made an investment of Rs.571,000/- and entered the market as a ‘long’ player. However, with the upcoming quarterly results looming, you are concerned that unfavourable figures may lead to a significant decrease in stock price. To protect yourself from a potential loss, it is wise to hedge this position.
We can hedge the spot position by entering a counter position in the futures market: ‘long’ in the spot, ‘short’ in the futures.
Here are the short futures trade details –
Short Futures @ 2285/-
Lot size = 250
Contract Value = Rs.571,250/-
We are long on Infosys in the spot market and short on Infosys in futures, but at different prices. Don’t worry about the price change; we are ‘neutral’ about our position. You’ll get a better understanding of this shortly.
No matter which way the price goes, with a hedged position, no gains or losses will be made. It is almost as if it has become indifferent to the market environment. As stated, hedging individual stock positions is simple; by using its futures contract and ensure the lot size and number of shares are equal in order to perfectly hedge the position. Otherwise, the amount of profit and loss may differ, raising a few caveats.
The response to these queries is not easy. Soon we will comprehend the explanations. Moving on, let us explore how one can protect multiple spot positions (typically a portfolio). First, we need to understand what is known as “Beta” of a stock.
– Understanding Beta (β)
Beta, indicated by the Greek symbol β, is a major element of market finance, being utilised in a diverse range of ways. It is an opportune moment to discuss it further, particularly its use for hedging portfolios of stocks.
Beta indicates the degree to which the stock price responds to movements in the market. It enables one to answer questions such as –
The beta of a stock can take any value greater than or equal to zero. In contrast, the beta of market indices (Sensex and Nifty) is always +1. To provide an example, assume BPCL’s beta is +0.7; this implies certain conclusions.