Understanding Hedging in Futures Trading

Everything About Hedging

One of the most practical and essential uses of futures involves hedging. In situations where market movements prove unfavourable, hedging offers a method to guard against losses for your trading position. To offer an example, let me attempt explaining what hedging really entails.

Seeing an opportunity, you decide to transform the barren land adjacent to your residence into a flourishing garden. You invest efforts to water and nurture it regularly, and after considerable work, your modest plot of land grows lush and the flowers bloom. Unfortunately, alongside admiration, your garden begins attracting attention from some local cattle which graze away your grass and trample on your flowers. To take control of the situation, you devise a simple solution—construct a fence or 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:

Your Portfolio as a Garden: You nurture a portfolio by selecting each security after diligent analysis, and commit a significant amount of your resources to it. This proves akin to tending to a garden that you cultivate.

Market Volatility as Cattle: Once your funds are deployed in the market, you may realise that a turbulent period lies ahead which could lead to declines in your portfolio. It resembles cattle straying onto your lawn and trampling on your blooming flowers.

Hedging as Fencing: To safeguard your market positions from losses, constructing a portfolio hedge using futures proves akin to erecting a fence around your garden.

I hope the analogy above provided you with better understanding of ‘hedging’. As earlier mentioned, it constitutes a strategy to protect your market position against potentially unfavourable movements. Do not be mistaken however; hedging can secure individual securities as well, although with some limitations.

Hedge—But Why?

This is a question that emerges frequently in debates about hedging: What purpose does it serve? Think about this scenario: An investor purchases a security for ₹100 and assumes the market will decline, which will cause their security to decrease in value. They can choose from three options:

Do not interfere and allow the value of their security to fall, anticipating it will recover in time.

Sell the security now in anticipation of repurchasing it at a cheaper rate later.

Hedge the position.

Let us consider an unfettered market situation when a trader invests in a security that drops from ₹100 to ₹75. Over time, it is predicted to bounce back to its original value. In this case, what would be the benefit of hedging?

It becomes clear that when a security drops from ₹100 to ₹75, that represents a decrease of 25%. To move back to the original investment value, however, the security would have to appreciate 33.33%. In other words, it requires less for the security to decline than it does to appreciate. From my experience, I can tell you securities do not usually rise substantially unless there exists 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 repurchasing at a later stage, presents a challenge in timing the market and consequently, the trader will forfeit long-term capital gains 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 receiving an immunisation.

Understanding Risk

Before we proceed to comprehend how we can guard our positions in the market, it proves essential to understand 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 equity 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 security or stock future, you become subject to both of these types of risks.

The stock market proves unpredictable, and many variables can cause share prices to fall. The security can experience losses due to a variety of factors, including market conditions, economic downturns, and adverse news about the company whose equity you’ve invested in:

Declining revenue

Declining profit margins

Higher financing costs

High leverage

Management misconduct

It proves noticeable that all of these potential risks are company-specific. As an illustration, let us say you have invested ₹1,00,000 in Infosys Limited. When the firm reveals its revenues have dropped, it follows that their shares will also decrease—leading to a loss on your investment. Conversely, this news would not affect the share price of competing companies such as Wipro or HCL Technologies. In such cases, only the company itself is exposed to this kind of risk which can be considered ‘Unsystematic Risk’.

Mitigating Unsystematic Risk Through Diversification

Investing in a diversified portfolio constitutes an excellent method to mitigate unsystematic risk. Rather than investing all the capital in one company, it proves advisable to choose two to three different companies from different sectors. Suppose half of your capital was invested into Infosys and the other half was invested into ICICI Bank Limited; if the share price of Infosys declined due to unsystematic risk, only half of your investment would be affected. You can raise the number of securities in your portfolio further, with more diversification meaning less unsystematic risk.

This raises the question of how many securities a well-rounded portfolio should possess for the purpose of full diversification. Research has determined that a maximum of twenty-one shares proves sufficient to obtain the required scattering, whilst any quantities beyond this likely offer only minor additional benefit.

The graph depicted below should illustrate effectively the benefits of diversifying portfolios.

The graph above clearly demonstrates how diversification works to reduce unsystematic risk. After a certain point, which appears around 20 securities, the graph begins to flatten, indicating that the unsystematic risk can no longer be fully mitigated. What remains of this risk is called ‘Systematic Risk’.

Understanding Systematic Risk

Systematic risk constitutes the type of risk that applies to all securities, 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:

Contraction in GDP

Interest rate tightening

Inflation

Fiscal deficit

Geopolitical risk

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 securities are subjected to this type of risk; given the example of a portfolio consisting of 20 securities, if there exists a decrease in GDP, they will all likely decline. Because such risk proves inherent to the system, it cannot be diversified away; though it can be hedged against. It proves important to note that hedging and diversifying are different techniques.

We should diversify our investments to reduce unsystematic risk, and hedge them to counterbalance systematic risk. Understanding this distinction proves fundamental to constructing resilient portfolios capable of weathering various market conditions whilst maintaining exposure to potential returns.