Nobody wants to lose in the stock market, not even the capital or the profit the position has generated, which has not yet been closed. Investors always seek ways to safeguard these profits, and hedging is undeniably the best option one can choose.
Hedging serves as a crucial risk management strategy in the dynamic world of Indian equity trading, providing participants with a valuable tool to offset potential losses. A straightforward and effective method involves buying a Put Option against an existing Buy trade. This strategic move involves purchasing a Put Option at a premium, ensuring that losses in the primary asset are cushioned in the face of adverse market movements.
Let’s delve into the mechanics of this strategy through a simple example:
Scenario:
Let’s say an investor decides to purchase 1000 shares of Stock X at the rate of Rs. 100 per share. Simultaneously, to protect against potential downturns in the market, the investor also opts to buy 1 lot, consisting of 1000 units, of a 100 Put at a premium cost of Rs. 5. This simultaneous purchase of shares and a corresponding Put Option at a set premium establishes a risk management approach.
If the stock falls to Rs. 70, the loss on the stock is Rs. 30. However, the rising value of the Put Option offsets this loss, resulting in a near-equivalent profit, considering the initial premium paid.
If the stock rises to Rs. 130, the profit on the stock is Rs. 30, while the loss on the Put is limited to the premium paid (Rs. 5).
This example illustrates the essence of hedging limiting potential losses while allowing for reasonable gains. The cost of hedging, represented by the premium of the Put Option, is a fraction of the underlying asset’s value.
Hedging Practices:
Initiate with Hedge:
When: This method is Utilized in circumstances characterized by uncertainty regarding the initiation of a trade, the strategy of initiating with a hedge provides a valuable tool for traders. This approach is particularly beneficial when there is a lack of conviction or confidence in the market direction. By incorporating a hedge right from the start, traders can navigate the unknown downside with a sense of assurance, even in situations where their confidence in the trade is relatively low. This practice not only acts as a risk management technique but also instills a level of confidence that may otherwise be absent when entering into a trade with ambiguous market conditions.
Repair with Hedge:
When: This strategy comes into play when an ongoing Buy position is in close proximity to the predefined stop-loss level. In such scenarios, purchasing a Put option proves to be a prudent move as it acts as a protective barrier against potential further losses without necessitating an immediate exit from the existing trade. This approach is commonly employed during pivotal events such as earnings announcements or policy decisions, providing traders with a risk management tool to shield their positions from adverse market movements. By strategically incorporating Puts into existing positions, traders can effectively mitigate risks and navigate through volatile periods with greater financial resilience.
Lock Profits with Hedge:
When: Implemented when a trade has already yielded profits and traders face the dilemma of whether to hold onto the position or book profits, the strategy of buying a Put option at this juncture serves as a safeguard. This approach secures the existing profits, introducing a protective layer that minimizes potential losses in the event of a market reversal. By adopting this practice, traders strike a balance between capitalizing on current gains and protecting themselves from unforeseen downturns. This tactical use of Put options during a profitable phase adds a layer of risk management, allowing traders to navigate market uncertainties while preserving the fruits of their successful trades.
Conclusion:
Hedging is a practical risk management approach that can be seamlessly integrated into trading strategies. By acknowledging the premium cost associated with buying a Put Option, investors ensure that potential losses are curtailed. However, it’s crucial to note that while hedging can prevent further losses, it cannot reverse losses already incurred. It is important to highlight that the same hedging practices are applicable to bearish trades, involving selling stocks (mainly in futures) and buying Call Options.
Disclaimer: This blog has been written exclusively for educational purposes. The securities mentioned are only examples and not recommendations. It is based on several secondary sources on the internet and is subject to changes. Please consult an expert before making related decisions.
