How to hedge your stock portfolio?

Vikas SinghaniaTrade Smart OnlineUnlike debt and fixed instrument markets, equity markets do not give steady and assured returns over small intervals. Over the long run, equity markets are known to give the best return but in the interim period they are subject to volatility. Every year markets give at least one or two sharp drops and every three or five years there is a big fall in the market. But there is a way through which the volatility of a stock or an entire portfolio can be reduced. This is called hedging.Hedging can be compared to insurance that we as individuals take. The reason one takes a life insurance cover is to ensure that the near and dear ones left behind do not fall in a financial crisis. In other words an insurance cover helps iron out financial volatility in one’s life. Similarly a hedge smoothens out returns for a portfolio or a stock. Those hedging their investments are preventing themselves for any negative turn of event. It is not necessary and financially feasible for an investor to carry a hedge at all points of time. But normally a crisis or a fall leaves enough tell-tale signs. Volatility generally increases ahead of a sharp move. Most of the severest of fall were always a result of an event not unfolding in a manner in which market expected it to. Rather than holding a hedge for the entire period of the stock or portfolio holding an investor can create a hedge just before the event. There are chances that uncertain events can cause the investment to move drastically and would need to be protected. But these risks are outliers and hedging against all outliers is not a feasible option. This is because hedging just like insurance has a cost attached to it. Hedging against risk is done by financial instruments which cost blocking of some capital and sacrificing return if the risk does not materialises.  Financial hedge is normally created by using derivative instruments. Derivative instruments like futures and options were created for the purpose of hedging but soon became a tool of speculation. Nonetheless their utility as a hedging instrument is intact in fact higher liquidity on account of speculation has resulted in lowering of cost.As the legendary investor Warren Buffett says protection of capital is the number one purpose of an investor. Hedging thus serves to protect capital but at a cost. But unlike insurance, financial hedges do not offer complete protection of the portfolio. A portfolio is normally under-hedged or over-hedged, rarely is it rightly-hedged. Say, you have a portfolio which is valued at Rs 16 lakh, in this case the hedge could be either of Rs 12 lakh or Rs 18 lakh. Thanks to the lot sizes of hedging instruments such as options and futures.Pricing of hedging instrument depends on the time duration for which the hedge is needed and volatility of the underlying instrument. If the hedge needs to be kept opened for a long period of time, then the cost of doing so will be more as uncertainty will increase with time. Similarly, if the portfolio or stock is more volatile, then the cost of hedging will be higher as compared to hedging a portfolio which is less volatile. The simplest way to hedge is to buy a put option of either the stock one is holding or of the index if there is a portfolio. So as is the previous example if a portfolio is of Rs 16 lakh, three put options would cover a hedge of Rs 12 lakh while four put options would be needed to cover Rs 18 lakh of portfolio. Since the value of Nifty is around 8,000 and each option has a lot size of 75, the coverage is of 8000*75=Rs 600,000. The cost of investing will be the value of put option. Say if the put option is of Rs 100 per contract the total value is Rs 7,500. Other factors also needs to be considered here as in the fall in option price to the fall in portfolio. One can really get into the depth of the right size of a hedge, but for a retail investor it is better to start off with at least covering the portfolio to the maximum possible limit. Just as in real life money cannot replace the person who has died, but there is at least some comfort that financially one’s life is not disturbed.One should remember that the put position is taken as a hedge and not a trading position. As in case of an insurance one expects that the no one has to die to get the insurance claim, similarly the expectation here is not to profit from the put option but in case if the market does fall the impact would be minimum. Another way to hedge the portfolio is to take a short future position, which would be like shorting the individual stock or the index. Mutual funds and professional traders use sectors which have a negative correlation to each other to lower the impact of a fall in the market. If there is a fall in the market on account of certain events, fund managers pile up on defensive stocks from the consumer goods or pharmaceutical space.  Hedging for a retail investor is important as capital is scarce for them. They need to desperately protect it. But one point worth noting is that hedging comes at a cost, both to the capital and returns. As equity markets are a function of risk and return were higher risk would result in higher return, any curtailment of risk by buying options would impact the portfolio return.