What is Hedging in Stock Market: Types and How it Works

The stock market is a game of probability, the more the odds are in your favor, the better are your chances to make money in it. Volatility is an inherent part of the stock market and there is always an element of risk involved in trading in the market.  

Therefore, prudent investors always strive to minimize investment risks and stack the market odds in their favor.  One of the best ways to do that in the stock market is to hedge your investments. In this blog we’ll understand in detail what is hedging in stock market and how we can do it effectively. 

 

 

What is Hedging in stock market? 

Hedging means to safeguard yourself from various losses occurring from unforeseen circumstances. You can correlate hedging with insurance that you purchase in your real lives for you, your loved ones or for your personal belongings, so that it minimizes your losses from any bad events in future.  

In financial terms, hedging is known as a risk management technique that delves on eliminating the threat of uncertainty and minimizing losses in case of any unexpected future event.   

In the world of stock markets, volatility causes unexpected price movements in stocks that could result in a loss of capital for an investor. Thus, to nullify the effect of unforeseen variations in stock prices, sensible investors hedge their investment by offsetting their position in the underlying asset i.e. countering their existing position by taking an opposite position. You can hedge your capital by learning from the best stock market learning app and maximize your returns. 

 

 

How do you hedge a stock? 

Let's understand in detail with an example:  

Suppose you have 100 shares of X company at a current market price of Rs.1000 per share. Now you are of the view that the share price of X could go down soon but at the same time, you also don't want to sell your investments.  

So, in this case you can always buy a put option with a strike price of 950 that will expire in a month. This is called 'Options' which could give you the right (but not the obligation) to sell your shares at Rs.950. Now there are two possible outcomes: 

i) If the share price of company X drops to 900, you can exercise your rights and sell them at Rs.950 that will limit your losses. 

ii) On the other hand, if the stock price rises than the current market price of Rs.1000, then you can let the option expire after one month. 

  

This is called hedging that assists you manage your portfolio efficiently and protects you from potential volatility risks. Though hedging is a very good tool to protect your investments but there are certain downsides of it that you need to keep in mind such as: 

- There is additional cost attached to hedging in the form of premiums for options and other derivatives 

- It requires careful analysis and market knowledge to perform hedging as it should align with your investment strategy. 

There are other safer hedging avenues too such as Index funds or Exchange Traded Funds (ETFs) that track a specific market index or sector which are less volatile in the long run as compared to options and futures. 

 

 

What are Hedge Funds? 

Hedge funds are instruments vehicles where high-net-worth individuals, Domestic institutional investors and Foreign Portfolio Investors pool their money to generate higher than market returns through investment avenues. These funds are managed by hedge fund managers who are professional investment managers, and their target is to generate returns that are higher than the market returns. These are the following characteristics of hedge funds: 

- Hedge funds are invested in different types of asset classes such as equities, options, futures and currencies for both the long and short term. 

- These funds are mostly limited to HNIs, DIIs and FIIs because of their high fees and high minimum investment requirements. 

- These funds are capable of generating abnormal returns. 

 

 

Types of Hedges in stock market 

An investor hedges in the stock market by trading in diverse commodities, currencies or securities. Hedging in stock market is broadly classified into the following kinds: 

 

1). Forward Contract 

A forward contract is a customized financial agreement between two parties where they agree and are legally binded to buy and sell an underlying asset at a predetermined price on a specified future date. This type of derivative contract helps in hedging against unpredictable price variations. Forward contracts consist of forward exchange contracts of diverse assets like currencies, commodities, equities and so on. 

  

Ex- For example, a farmer wants to secure his wheat price in case the price of wheat falls in the future. On the contrary, a bakery also wants to lock in the wheat price at the current market price as he feels it will increase in the future.  

Here both could enter a future contract, where the farmer will sell 100 kg of wheat to the bakery at Rs.25/kg. Now after three both the parties are legally binded to honor the contract at the preset price irrespective of the current market price. 

 

2). Futures Contract 

A future contract is a standardized financial agreement between two parties where they agree to sell an underlying asset at a preset price on a specified future date. In nature it is a bit like forward contract but also has some characteristics which makes it distinct to the latter such as: 

1. It is highly regulated by stock exchanges 
2. It is a standardized contract in terms of size, expiry, margin, etc 
3. It has lower default risk in comparison to forwards 
4. These are more liquid than forwards. 

  

Let's understand it with an example, if a trader is of the view that the gold prices could rise in the near term. Therefore, he purchases a gold futures contract at Rs.50,000 per 10 grams to be delivered in three months. Here there are two possibilities: 

1. If the price of gold rises to Rs.52,000, then he will make a profit of Rs.2,000 per 10 gram. 
2. In case if the gold price falls to Rs.48,000, then he will incur a loss of Rs.2,000 per gram.  

 

3). Options  

Options hedging is another popular risk management strategy where investors opt for such contracts to hedge potential losses due to market volatility. This hedging strategy allows them to minimize their potential losses while still leaving room for potential gains. You can refer to the example given in the start of the blog to understand how Options work as a hedging strategy. 

 

4). Pair Trading 

Pair trading is a kind of market-neutral strategy where an investor takes a position (long position) and nullifies it by taking an opposite position (short position) in another related stocks. Here the investor aims to profit from the relative price movements of the stocks.  

This strategy works on stocks that are historically correlated. When temporary price deviation in these stocks takes place, traders place their money on the reversal of their prices to their historical trend.  

For example, there are two correlated stocks such as HDFC Bank and ICICI Bank, if HDFC stock outperforms ICICI, the trader may take a short position in HDFC and long position on ICICI with the hope of the price reversing to their historic trend. If everything goes per the trader's plan and price relationship between both the stocks normalizes, trader closes their position and books profits. 

 

5). Currency Hedging 

Currency hedging is used as a risk management strategy by investors, traders and business to brace themselves from unfavorable fluctuations in the exchange rate of foreign currency transactions.  

It is a popular hedging strategy carried out by investors dealing in currency markets to protect their international investments from currency depreciation. Let's delve into this strategy with an example 

For example, suppose you have bought US stocks worth $10,000 when the exchange rate is USD/INR = 83. With time your portfolio rises by 10% and reaches $11,000 but during the Rupee also strengthens against the Dollar to INR 80 per USD.  

At INR 83, your $11,000 after conversion would have been INR 9,13,000 but due to Rupee strengthening to INR 80 per dollar, your $11,000 dollar would be INR 8,80,000 resulting in an INR 33,000 loss due to forex changes.  

To safeguard his foreign investments against INR appreciation, investor may purchase USD/INR future contracts at INR 83 for $10,000. Now, if the INR strengthens against the USD to reach INR 80 per USD, then the investor will incur loss on currency conversion but will earn profits on future contracts that will nullify his losses. 

 

 

Final Thoughts 

Hedged risk management is a strategy applied by investors in order to secure their portfolios against potential losses through the creation of an offsetting position in a related asset or financial instrument. Since there are numerous hedging strategies, each having their own advantages and disadvantages, investors must first understand their goals and risk tolerance before applying any hedge.