Hedging and Derivatives

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How to use
Identify a security that you think will be more volatile and less resilient to the upheavals you anticipate in the market. Determine the amount you wish to hedge, and your position in the market .(long or short) Try and determine the minimum and maximum price by which the stock will fall. Depending upon your position, divide the hedge by the expected increase/decrease to calculate the amount of shares to buy. Place the order and watch the fun.

Be wary of
It can be quite difficult to find a good pair. If the security you originally owned had greater price fluctuations, you could actually end up with a greater loss Since you’re anticipating a time of greater volatility, support and resistance levels will probably be breached so calculating the expected fall can be quite tricky.

Options are like futures, only that in the case of stock options trading, the buyer or the seller have the rights, but not the obligation to carry out the contract. A put is the buyer’s version of the option, it gives him or her the right (but not the obligation) to sell a specified quantity of a security at a specified price (strike price) within a fixed period of time (until its expiration).

Stock options trading can be used for the purposes of hedging. Let us explore the concept of married puts-i.e, when you combine put options with an equivalent number of stocks.

How do they work
It’s pretty simple- let’s say you’ve bought twenty securities trading at Rs 52. You buy a stock options trading contract that gives you the right to sell the stock at Rs 50, at a cost of about Rs 2 each.

Thus the cost of your investment has increased by Rs 100, but the maximum loss you can incur for the investment is 2 per security, or a total of Rs. 100. On the other hand, there is no limit to the upside, as the puts will simply become worthless as your stock keeps rising.

When to use
When you’re bullish on a security but wary of short-term fluctuations When the options contract is cheaper to buy (which indicates that the market is bullish on the security)

Be Wary of
Married puts have limited risks- the only thing you really need to be worried about is the fine print of the contract. Also, remember, that as long as the option is outstanding, you cannot sell the security married to it.

Futures and options trading have a bit of a bad reputation, especially amongst conservative traders. While they may well have a point generally, conservative traders should realize that futures and options trading is extremely helpful for what they pay extreme attention to- Risk management.

MyValueTrade is an online stock trading platform and a stock trading app that combines simplicity with a choice between fixed brokerage and a per order charge. We have amongst the lowest brokerage in India.

We have recently written a post on The Basics of Risk Management, followed by a detailed article on how to use stop-loss strategies to minimize risk. Today, we shall talk in detail about the other method of risk management, i.e, hedging.

Hedging involves the use of derivatives, or futures and options trading. Futures and options trading is generally considered a highly advanced and complicated investment form and is often criticized because of being speculative in nature. However, their use in hedging is perfectly acceptable, and that’s where we’re going to restrict the scope of their use.

A financial contract is an agreement to purchase or sell an asset in the future at a predetermined price and date.

In simple terms, futures allow you to sell a security you don’t even own and buy one later in the future at a different price from now.

The best way of using futures to hedge risk is the classic ‘pairs trade’, i.e., investing in an opposite position to a security similar to the one you already hold.

When to use
You anticipate a general decline in the market but are optimistic for the long term You’re investing in a company you believe in but whose industry hasn’t proved itself in the market yet

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