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How to Hedge using Futures Contract?

Have you ever faced a huge loss in your trading career? And are you searching for the strategy to make a profit irrespective of market conditions or want to at least minimize the losses? Then you have landed on the right page. In this blog, we have discussed how you can hedge using futures contracts and suggested some hedging strategies with futures. Futures are a very good option to manage risk and for hedging. The word hedging means protection against loss. Hedging will not only limit the losses but also protect your profits from reducing. So let us understand how to hedge stocks with futures.

Risk profile

Before knowing the hedging strategies it is important to understand the concept of risk profile. Risk profile is a graph that shows the relationship between changes in price versus changes in the value of the position.

Hedging with futures

To understand this, let's consider the risk profile of an oil buyer and oil seller.

An oil buyer is a person who's concerned about an increase in the price of oil. As the price of oil increases the oil seller gets more money. As the price of oil goes down moving to the left the oil seller receives less money.

Hedging for Buyer of Futures Contract

Let's say the buyer is a gasoline refiner. In this case, as the price of oil goes up the price of input oil used to produce gasoline goes up and it causes this company to lose money and of course, if the price of oil goes down they will make money. So in order to hedge using forward and futures contracts, we need to look at the payoff diagrams for these contracts.

Payoff Profile for Buying Futures
Payoff Profile for Buying Futures

What happens in the futures contracts is we are buying a forward or futures contract which basically means that we're buying the commodity for a price today but we're not going to take delivery until some later date. So what happens if the price goes up we've already paid, we've already locked in our price we actually make money that means we hedge by locking profit.

Now if the price goes down then we are stuck with this commodity because we paid say 10$ and for now, it's only worth 9$. Here you have lost money.

The oil buyer is concerned about the price of oil going up if it goes up, they lose money. So, they take a position where they buy the futures contract that will make the money if the price goes up and again as shown in the diagram all the risk is eliminated in this position.

Hedging Payoff for Buyer Using Futures Contract
Hedging Payoff for Buyer Using Futures Contract

Hedging for Seller of Futures Contract

There is also the opposite position where you are selling the forward of the futures contract.

In this case, you are selling at a price and then you will close out your position by buying back the contract in the case of a futures contract. When you buy it back, if you have to buy it back at a higher price you will lose money and if you can buy it back at a lower price you will make a profit because you've already sold it at a fixed price.

For example, you sold it at 100 if it's now 90 and you buy back the futures contract for 90 you'll have made 10 dollars. So, you notice that the payoff diagrams for the forward and futures contracts look similar to the risk profiles. So in order to hedge, we'll take a position that has a payoff that is the opposite of the risk profile. So here we have the position for someone who is an oil seller.

Payoff Profile for Selling Futures
Payoff Profile for Selling Futures

We saw that in the risk profile as the price of oil increases, value increases. And as the price of oil decreases, value decreases. So, you want a position that goes in the opposite direction that makes money when the price goes down. But you are willing to accept losing money if the price goes up and that would be selling the futures contract.

If you put these two positions together you will get the flat horizontal red line where if you lose a dollar because the price went down you make a dollar in this position with your futures contract and that offsets the loss if the price goes up and you make money. See the next graph where you lose money in this position so you get this horizontal line which essentially says there's no risk if the price goes up there's no change in value if the price goes down there's no change in value you've essentially locked in your position.

Hedging Payoff for Seller Using Futures Contract
Hedging Payoff for Seller Using Futures Contract

Now in the real world, you are not going to be able to get this perfect hedge where there's absolutely no risk but if you can reduce some of this risk by flattening out this line that reduces some of the risks.

Hedging strategies

Now in the real world, you will not be able to eliminate all risk and, in some cases, you may not want to eliminate all the risk because when you do this perfect hedge you also eliminate the upside potential. So, you may just want to reduce some of the risks to a more tolerable level. And this is the time when you make use of heading strategies. Let’s understand some very useful heading strategies.

Hedging by creating a cash-futures arbitrage

This is the strategy of buying a stock in the cash market and selling equivalent futures. This is widely used and the most passive form of hedge. As futures are sold in minimum lot sizes, you need to match your cash market position to the lot equivalents.

Hedging by locking in a profit position

By this method, you can lock your profits, specifically when you expect the market to become volatile. For example, assume that you have bought 2000 shares of HUL one year back at Rs.650. After 1 year the stock price has increased to Rs.950. Since you are a long-term investor in HUL, you do not want to sell your cash position. But instead of this, you can sell equivalent 2 lots of HUL futures at around Rs.955. This way the price difference is locked in as your assured profit. Now even if you do nothing in that month your profit is assured. In this position, you can roll over the short futures each month and also earn the premium on a short roll.

Hedging by locking in a loss on your position

This strategy can be used to limit your losses. This will be helpful when you expect some structural damage to the stock in the short term but you are confident in the long term. In the immediate term, it makes sense to lock in your losses.

Consider, for example, you purchased XYZ motors stock at Rs.370 but due to world events, the stock suddenly fell to Rs.355. Here is the strategy you can apply to hedge losses. Let’s see with values:

Buying price = Rs. 370/share

Sell 1 lot futures at Rs. 358

Loss locked = Rs.12/share

Current market price = Rs. 355

Roll premium for 6 months = Rs. 9/share

Notional loss Rs. 22,500/_

Reduced loss Rs. 3/share

As you roll over each month and earn a premium, you automatically reduce your loss on the position. You can take a fresh view of the position subsequently.

Protecting risk using ‘Beta Hedging’

What if you are holding on to a portfolio of stocks and you are worried about a global risk that could take the entire market down. The obvious answer will be to sell the nifty futures. The question, then, is how much nifty futures are to be sold so that your risk is fully hedged. That is where Beta Hedging comes into play. Let us understand how it works with a example:

Consider the portfolio of Mr. Ram who has 12 stocks in his equity portfolio

Let the current value of the equity portfolio of Ram = P = Rs. 35,60,000

Let weighted average beta of the portfolio = Q = 1.18

So nifty futures to be sold for perfect hedge = M = (P x Q) = 35,60,000 x 1.18 = 42,00,800

Now, let the market lot size of NIFTY which is 75 units be and the current price of NIFTY =10,392

Therefore, market value of 1 lot of NIFTY = N = 75 x 10,392 = 7,79,400 Rs

Number of nifty lots to be sold for beta hedge = (M/N) = 5.39 lots

This way you can calculate the number of NIFTY lots that are required to be sold to Beta Hedge. Here the value of the number of lots that are to be sold is in fraction so obviously, you cannot sell in fraction. Therefore, as per your wanting you can either sell 5 lots or 6 lots.

In this way you can hedge with futures contracts. Hedging with futures contracts consists of taking a position as a payoff that is the opposite of the risk profile that is being hedged. This allows the losses from the position in the commodity to be offset by gains in the forward or futures position.

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