Safety first while trading! Cost of hedging wouldn’t go beyond 3-4% of your position

It will be a wise move to pay a nuisance cost for a likely unforeseen event.

Let’s talk about ‘Hedging’ again today.

Financial dictionary adaptation of Hedge is ‘an investment to reduce the risk of adverse price movements in an asset’.

In simple words additional position that creates compensatory positive cash flows when the original position starts bleeding. A simple example is Life Insurance, a hedge against Death.

But, more than ‘what is hedge’, it is important is to understand How to and When to Hedge.

Taking a Hedge is most ideal and shall be inculcated as a natural instinct as and when there are extremes. Whenever we are in extreme fear (would kind of come naturally) or in extreme greed.

‘Fear’, I do not want to elaborate as any prudent trader would like to have a known loss strategy in the times of extreme pessimism, but convincing ourselves to do the same in the most hunky-dory times is difficult.

It is empirically proven that the house always wins; hence, in most of the over-optimistic times, there is a possibility that while the entire participation is in the gung-ho mood and the market has something entirely opposite planned for us.

Not many of us resort to Hedge may be just because of the very first characteristic of hedging, it comes at an irrecoverable cost.

The benefit is very simple -- our maximum loss is defined hence just track profits, do not track losses.

Now comes the answer to the question How to Hedge?

To hedge a position in cash (participating F&O stocks) & futures market, use options (Buy Put for Long Futures & Bought Stocks, Call for Short future).

Most of the times the cost of hedging wouldn’t go beyond 3-4% even if the hedge is kept for a good 20+ sessions. I have always found prudence in choosing the strike close to the current market price.

Now for the stocks, not participating in F&O, If one is trying to hedge a bunch of stocks against market falling then the following equation viz.

Contract value (Lot Size * Strike Price)of Index Put Options Bought = 2-3 X Portfolio Value, has made sense for me a few times. However many times behaviour of a peculiar portfolio could be very different, hence try resizing and exiting, keeping this hedging as last resort.

Last but not least, if it is about short options to be hedged, take a compensatory trade in higher call or lower put (OTMs) depending upon the position.

In case of entrapment into options that have gone in the money, I would rather Buy multiple of OTMs so that adverse move can be reasonably compensated.

While if one is trapped in the Long Option position, restrict selling options 1:1 unless otherwise it’s the week of expiry and one can keep a close track of it.

(The author is CEO & Head of Research at Quantsapp Private Limited.)

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