It is a basic human instinct to want to earn only profits, and to also be protected from any possible loss. Therefore, any investor would love to have a protective cover in case the market doesn’t perform as per their expectations. Let’s understand Hedging.
“Hedging” is a way to form that protective cover. In simple words, it limits your maximum loss on an investment. But, nothing in this world comes with a magical risk-reward ratio; that would provide you unlimited returns while minimizing your loss. This is true for hedging as well; although you can limit your downside, the upside i.e. the maximum return also gets reduced by some amount.
So, what can an investor do in such a scenario? The answer is that an investor should be rational; and they should realistically try to maximize their return with a tolerable level of risk that they can afford. This article is going to explain one such hedging strategy using which you can protect your losses in an Options Contract.
Before applying this strategy, you need to form an opinion about the market; whether you think the market will fall or it will go up.
Let’s try to understand hedging through an example with the below assumptions about a hypothetical stock market index.
- Current Market Price (CMP): 9860
- Premium for 1-month 10300 CE: 120
Investor’s Opinion: Market should fall, but even if it goes up the price should stay below 10300.
Strategy: Follow the below steps:
- Sell 1-month 10300 CE: Since we believe the price will stay below 10300, our expectation is that this option will expire out-of-money and we will be able to earn full 120 premium.
- Breakeven point: 10420: We have already earned a premium of 120, so we will not enter losses until the price goes above 10420 level.
- Keep tracking the market very closely for any fluctuations. At any point that the price reaches near 10400 level, enter a future contract expiring on the same day as the CE that you’ve sold.
- IMPORTANT: After entering into the future contract, it is crucial to consistently track the market. If it again starts falling and goes below 10400 level, then the investor should sell the futures contract. Otherwise they are exposing themselves to unlimited risk of the market falling.
- In case of a bullish market; the opinion that we formed in the beginning was wrong and the price will go beyond 10300; but since we’ve entered into a future contract at the right time, we’ve hedged our position; and will be able to close our position on the expiry without incurring any profit or loss.
- In case of a bearish market; the opinion turns out to be true and the CE option that we’ve sold will be out-of-money on expiry; so we’ve made a profit of 120 in the form of premium.
Profit/Loss Situation – Hedging Options Using Futures
- Scenario 1 (best-case): Market stays below 10300. If the investor’s opinion turns out to be true, they get to keep the premium amount of 120 per unit and this is their maximum profit potential.
- Scenario 2 (still in profit): Market stays between 10300 and 10420. In this case, although the investor’s opinion wasn’t exactly correct; but still they had earned a premium of 120 at the beginning which brought the breakeven point to 10420. Therefore, the investor’s profit will reduce accordingly but they would not be in a loss.
- Scenario 3 (no profit / worst-case): Market goes beyond 10420. If the market goes beyond 10420, then the investor’s initial expectation was quite wrong. However, the investor had entered into a futures contract as soon as they realized that their opinion may turn out to be wrong. The investor will be able to buy the share at the agreed price in the futures contract (should be below 10420); and they will sell this share to the option-buyer whose option is in-the-money and will be exercised. Thus, the investor will either make minimal or no profit in this situation.
If this strategy is properly followed, then an investor can maximize their returns while trying to keep the risk to a minimum level. However, one extremely crucial point to keep in mind is that once you’ve entered into a future contract when the price reached 10400 level, you have to constantly track the share price to see that it doesn’t start falling again. If market starts falling again before the expiry of the option, then REMEMBER TO SELL FUTURE back in the market, otherwise you’ll have to honor the future contract on expiry date and you will lose money if the market becomes bearish before expiry.
Hope you enjoyed reading this article, do let me know your thoughts in the comments below!
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