Hedging is a risk management strategy employed to offset the losses in your existing asset by taking an opposite position in a related asset.
For the Indian equity and equity futures and options participants, this is generally simplified into a single transaction:
Buy a Put Option against your Buy trade
As we all know Put option that costs premium has a characteristic that such premium rises in value if the stock or index that the option belongs to (underlying) falls. In case if its underlying rises Put option will fall.
This perfectly fits into the definition as a Buy trade will lose money if the underlying falls, the Put option will rise in value. One good thing about the Put option is that the maximum loss in any case is just the premium you pay to Buy the Put. This premium is just a tiny fraction of the value of underlying.
In other words, we can say the cost of this hedging is the Premium of Put option. If we are ok with the cost, the Put option will make sure that we will not have any further loss. Some numbers can explain this even more clearly.
Buy 1000 Stock X @ 100
Buy 1 lot (1000) 100 Put @ 5
Now if the stock goes down to 70, our loss on stock would be 30. However, since we have the Put, where its premium will rise in such case, we would have an offsetting profit of little less than 30, considering the cost we already paid.
On the other hand, if the stock goes up to 130, our profit on the stock would be 30, but the loss on Put will be just 5, as that is the premium we paid, which would go in vain.
Now, let us see how hedging is practiced to manage risk.
#1 Initiate with Hedge:
Here the offsetting position is entered into right at the time of initiation of trade.
When: Situations when we are in two minds whether to take the trade in first place. Initiate with Hedge takes away the unknown downside so even with low conviction in the view one can execute the trade with confidence.
#2 Repair with Hedge:
This is the most used practice hedge. Here, one has already Bought and is Buying Put so that existing position can be repaired, and no further loss occurs.
When: This is generally practiced when one is very close to the stoploss level, a point beyond which taking loss will be unbearable economically. To prevent further loss without having to exit out of the Buy tradem one Buys a Put to stop further loss by paying a cost (Premium).
Lot of Investors also resort to this practice in times big events like results, policy decisions. Here the Put options are bought before the event and are sold after the event. In case of an unforeseen fall led by the event, those losses can be offset by the profit in Put.
#3 Lock Profits with Hedge:
In this practice also Put option is bought some time after the Buy trade but after the Buy trade is already in profit.
When: After the trade goes into Profit and one is in dilemma of booking profit or holding on for further gain. This is the time when one can Buy Put and lock profit. This is done so that in case of a reversal there is no loss in profit (except the premium cost). The trade remains active if after a small pull back the stock starts rising.
These are some of the hedging practices that are used to make sure that the risk is well managed. As a result, by paying a certain cost (premium) one keeps trading without a negative surprise.
Before we conclude, it is customary to mention that hedging can reduce/ remove further loss, but it cannot undo a loss already incurred.
Also, the example trade mentioned was of Buy stock and Buy Put. However, the same hedging practices apply to a bearish trade where there is Sell Stock (majorly done in Futures) and Buy Call.
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