Hedging a Single Stock Position and Understanding Beta

Hedging a Single Stock Position

We shall first discuss hedging a single stock future, as it proves straightforward to implement. Its limitations should then be acknowledged before delving into the process of hedging a portfolio of securities.

By purchasing 180 shares of Tech Mahindra at ₹1,245 per share, you have made an investment of ₹2,24,100 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 share price. To protect yourself from potential loss, it proves 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:

Hedging Parameters:

Short Futures @ ₹1,248

Lot size = 180

Contract Value = ₹2,24,640

We are long on Tech Mahindra in the spot market and short on Tech Mahindra in futures, but at different prices. Don’t worry about the price differential; we are ‘neutral’ about our position. You’ll gain better understanding of this shortly.

Let us examine the consequences of various Tech Mahindra prices on our positions, for example:

Scenario Analysis:

Tech Mahindra PriceSpot Position P&LFutures Position P&LNet P&L₹1,180-₹11,700+₹12,240+₹540₹1,210-₹6,300+₹6,840+₹540₹1,245₹0+₹540+₹540₹1,280+₹6,300-₹5,760+₹540₹1,315+₹12,600-₹12,060+₹540

No matter which way the price moves, with a hedged position, minimal gains or losses materialise. It appears almost as if it has become indifferent to the market environment. As stated, hedging individual stock positions proves simple; by using its futures contract and ensuring the lot size and number of shares are equal, one can perfectly hedge the position. Otherwise, the amount of profit and loss may differ, raising a few caveats:

Critical Questions:

If I own a position in a security without a futures contract, like South Indian Bank, can I still hedge it? Would that be possible?

What if my position size proves relatively small—say ₹50,000 or ₹1,00,000—can I still hedge it? Let’s consider an example to determine the spot position value at ₹2,24,100.

The response to these queries proves not straightforward. Soon we shall comprehend the explanations. Moving forward, 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 security.

Understanding Beta (β)

Beta, indicated by the Greek symbol β, constitutes a major element of market finance, being utilised in diverse ways. It proves an opportune moment to discuss it further, particularly its use for hedging portfolios of securities.

Beta indicates the degree to which share prices respond to movements in the market. It enables one to answer questions such as:

• If the market increases by 2% tomorrow, what effect will it likely have on security XYZ?
• What is the degree of fluctuation for security XYZ in comparison to major stock indices such as Nifty and Sensex?
• What are the relative volatility characteristics of XYZ security compared to ABC security?

The beta of a security 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 Reliance Industries’ beta is +0.8; this implies certain conclusions:

Beta Interpretation for Reliance Industries (β = 0.8):

For every growth of 1.0% in the market, it is anticipated that Reliance Industries will appreciate by approximately 0.8%.

If the market sees an increase of 1.5%, Reliance Industries is projected to see a proportional rise of 1.2%.

If the market sees a decrease of 1.0%, Reliance Industries would drop by 0.8%.

As Reliance Industries’ beta registers lower than the market beta, at 0.8% versus 1.0%, it is thought to be 20% less hazardous than the market.

One can even say Reliance Industries relatively carries less systematic risk.

With HDFC Bank’s beta being 0.95%, it is believed that Reliance Industries proves less volatile and therefore carries less risk than HDFC Bank.

Beta Values Interpretation Table

This table provides a view of what beta values mean for securities. It should help you understand them better:

Beta Value Ranges:

Beta Range Market Behaviour Risk Characteristicsβ = 0No correlation with market Zero systematic risk0 < β < 1Moves in same direction but less volatile Lower than market riskβ = 1Moves exactly with market Equal to market riskβ > 1Moves in same direction but more volatile Higher than market riskβ < 0Moves opposite to market Inverse correlation (rare)

Sample Beta Values for Blue Chip Stocks

As of January 2025, here are the Beta values for a few blue-chip securities:

Blue Chip Beta Examples:

Company Beta Value Risk Profile HDFC Bank0.92Slightly less volatile than market Reliance Industries0.88Moderately less volatile than marketInfosys1.15More volatile than marketTCS0.95Slightly less volatile than market ICICI Bank1.22Significantly more volatile than marketWipro1.08Slightly more volatile than market

Understanding beta proves essential for constructing effective hedging strategies, particularly when protecting diversified portfolios. Securities with higher betas require proportionally larger hedge positions to achieve effective risk mitigation, whilst lower beta securities necessitate smaller hedging positions. This concept becomes particularly relevant when employing index futures to hedge individual stock positions or portfolios, as we shall explore in subsequent discussions.