Hedging in The Stock Market | What is Hedging for Beginners? What are The Benefits of Hedging?

Welcome to StayInform in today’s report, we will know about hedging in the stock market. How is hedging done? What are the benefits of hedging? And how can you ensure a loss? We will discuss this topic in detail today.

Hedging in The Stock Market

What Is Hedging?

Hedging is a type of insurance. Suppose you are sitting in a buy position on a stock or index. And the global situation changes so much that you think that the market will open with a gap the next day.

Then you are sitting in a short position. So if a recession occurs, you need to protect the position. So in this situation, you can hedge any call or put.

In this way, you can protect your current situation by hedging. Hedging is a part of risk management strategy. No matter what risk you take on a stock or index, you need to manage it with a strategy that how much risk you can take here or how you can ensure your loss there.

Advantages of Hedging

Hedging has both advantages and disadvantages. The advantage is that you can limit your losses here. You can make limited losses here.

Disadvantages of Hedging

But whenever you limit your losses, your profits also get limited there. And that too gets limited there to some extent. So in a sense, if you are a safe trader and work for limited losses and limited profits, then hedging is very good for you.

What Do Institutional Buyers Do?

Many institutional buyers, mutual funds or FIIs, deal only with hedging. If you want to work in an institution as a trader or investor, then you should first know how to do hedging. If you do not know how to do hedging, then you are not given a job there.

Why Is Hedging Very Important?

So hedging is very important. Because no matter what position people choose, suppose you are managing a portfolio of Rs 1000 crores and you do not know about risk management or hedging, then you will just buy or sell. So either you make a profit or you make a loss.

But if you hedge, your profit will be limited and your loss will not be too much. That is why hedging is very important. Then, hedging, as I said, ensures your safety.

Similarly, your potential profit is also a little less because on the one hand you have to bear a small loss. Then, hedging strategies usually involve F&O options. That is, if you are sitting with a stock on delivery, what can you do to hedge? You can hedge its future or its options.

That is why hedging strategies are usually done with derivatives. That is, you can either sell the future or buy the future or you can buy and sell the options.

Let Me Give You an Example.

For example, you are buying a house and you do not know what disaster is going to happen in the future. Either there may be a fire or a landslide, someone’s house may collapse, there may be a problem due to an earthquake. So what do you do? It is your risk.

What Do You Do To Avoid Risk?

So what do you do to avoid this risk? You buy insurance for your house. Now what happens if you buy insurance? Whenever such a situation comes, that disaster comes, or an earthquake comes, or a flood comes, or a fire occurs, then you will have a security of insurance that whatever happens to the house, but I have insurance for it. So what did you do here? Here you had your risk, it hedged you. In this way, you can protect your position by hedging.

Let’s See With a Financial Example

Let’s see this with a financial example. Suppose you buy Nifty futures at Rs 17,350.

And you think that Nifty is going to go up and it is going to go to Rs 17,500. That is why you are sitting in a buy position. But what do you have to do here? Risk management.

If Nifty does not go up, if the world situation changes and the market starts falling the next day, then you will have to face losses. So what can you do here? Here you have two options. You can either sell OTM call options, that is, if you sell the call option at some distance, then when the market goes down, those short positions will be there.

You will get the money you have sold on the call. Or you can buy OTM put options. That is, you can buy an out-of-the-money put option.

You can do either of the two. If you are long on the future, then you have taken the put and short on the Nifty. If you are long on the future, then you have taken a short position by shorting the call.

So a long position and a short position. You can do the opposite here. If you are sitting short on the Nifty, then you have taken a long position on the opposite.

Another Hypothetical Example

Let us understand the matter with another hypothetical example. Suppose there is a stock called XYZ, whose spot price is Rs. 600. Now you think that the stock will go up.

There are two situations here. You think the stock will go up. So what do you do here? You buy a call at Rs 5,800, which has a strike price of Rs 300, with a premium of Rs 300.

But you have to secure a position. You don’t know what will happen in the future.

And I need to secure my profit a little bit. So what do you do for that? You sell a call of Rs 6,200, which has a premium of Rs 145. So what did you do here? You paid Rs 300 to buy the call.

And Rs 145 is back to you. So what is your risk here? Rs 155. Because the difference will be the maximum loss.

Because the difference will be your loss. So what did you do here? You secured the loss. You limited it.

I will not lose below Rs 155. Now if the market goes up, if the market goes up by Rs 200, 300 or 400, then you are already in a position. So your loss is secured here.

Your Maximum Profit

And your maximum profit here, if the market goes up by Rs 300 or 400, then here you will have at least a profit of Rs 250. So how do you see it? Because you are already making a profit of Rs 200. So no matter how much it goes up, in-the-money, you will have an intrinsic value of Rs 200.

So the more the market goes up, the more the intrinsic value of your call goes up. As a result, your maximum profit will be there. So it can be 250 to 300 rupees.

But you have limited the maximum loss here to 155 rupees. Because the difference is 155 rupees. Here you have to bear the same loss.

In this way, you can hedge and limit your loss here. And if the market goes in your direction, you will get your profit there.

Another Example Is,

If the market starts falling, what do you do? If you think that the spot is going at 6,000 rupees and the market is going to go down or this stock is going to go down, then in that position, what do you do? You buy an in-the-money put which is priced at 220 rupees.

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And what do you do here? You sell an out-of-the-money put which is priced at 170 rupees. So what happened here? The difference between the two is 50 rupees. That is, your maximum loss will be up to 50 rupees.

And if the market goes up, your maximum profit will be 150 to 200 rupees. So, in this way, by hedging, you can secure your position in the market. It’s like buying insurance on your profit position.

Or on your long position and short position. So in this way, you can hedge here. There are many options for hedging.

You can spread bull call, bear call. There are many types of straddles, straddles, calendar spreads. We will tell about all these in detail in one article after another.

Now let’s See What Are Its Advantages.

The advantage of hedging, as I said, you can limit the loss.

And you don’t have to spread. You think the market will open a gap of 200-300 points. But if you hedge, your loss will be protected.

So the profit will be protected and the loss will be within the limit. Here you can limit the loss. Hedging increases liquidity.

Because the investor invests in different asset classes. If he takes a delivery, then he spends money for the future. Or if he spends money on the option, then he invests more money in it.

It Increases Liquidity in The Market

And you get the opportunity to invest in different assets. And when you hedge here, you get less margin.

Because you are selling a call and buying a call. So you have to pay the same amount for both. For example, you are buying a call for Rs 300. And you are selling a call for Rs 145. So you have to pay the difference of Rs 155 as margin.

If you short a naked call here, you can get a margin of Rs 1-1.5 lakh. But if you buy a call with it, then you have hedged. You have a basket and a spread.

In a spread, you have to pay less margin. As a result, your position is protected. Your loss is also protected.

And you are not paying much money there. So here are some of the benefits of hedging. Hope you understood the video well.

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Conclusions

In today’s article, you learned how important hedging is in trading, especially for new traders. Trading without hedging is like jumping into a fire. So hedging is a must for a successful trader. It will save you from unlimited financial losses.