We will look at understanding Hedging today. Financial dictionary defines Hedge as ‘an investment to reduce the risk of adverse price movements in an asset’.
In simple words an additional position that creates compensating profit when the original position starts making losses. Simple example is Life Insurance, a hedge against death. Now that we understand the meaning of hedge let us focus on when to hedge.
But before we do that let us understand two minor but crucial details of Hedge.
1. A Hedge always comes at a cost
2. Hedge can prevent from future damage but cannot undo past damage
Now let us understand, when to hedge? There are three scenarios where hedging becomes crucial, which has to do with dealing with Past, Present & Future risk of loss.
Past: Let us say one already has a position in Futures. The position starts incurring losses. Now many of us (including me at times) would not be willing to exit at our predefined stop loss level. When it comes to taking that bit of additional risk beyond our pre-decided stop loss level, it is advisable to create a hedge.
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Result: The position won’t create any more losses and we would still be holding the trade just in case the original futures trade turns around and becomes favourable after hitting the stop loss level.
Present: This one is my favourite. Here the hedge is created when the Futures trade is in Profits right now. In that case instead of getting confused about whether or not to book profit now, at an additional cost create an opposite position meaning a Hedge.
Now, if there is more profit in Futures in the coming time we will keep making more money but if the Futures trade starts losing from current levels our profit is locked.
Future: Now here, to safeguard against losses in coming times in a fresh Future trade, not many of us create Hedge. This is because of the very first characteristic, Hedge comes at irrecoverable cost. Still, have a big heart and create a Future trade and at the same time create a Hedge for safety. The benefit is very simple our maximum loss is defined hence just track profits, do not track losses
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Now that we understand when it is important to hedge. We also need to know how to create a hedge. As most of us know options are the best instruments to choose for Hedging. This is because with options there is always limited loss (only premium) and unlimited profit.
So, when we have to do Hedging by creating an Opposite position with options, we will do the Following:
Hedge Buy Futures position with Option to Sell or Put Option
So, to hedge a position in the Futures market, use options. Most of the time, the additional cost due to hedging wouldn’t go beyond 3-4% of Futures price.
As far as strike selection for options is concerned, I have always gotten better results in choosing the strike close to the current market price.
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