Avoid speculative F&O, but hedging can help

Real long-term investors seem to have shifted their attention from stocks to other products. At least 90% of overall trade value now takes place in derivatives rather than cash. Cash trading, or the buying and selling of shares where cash is paid and the delivery of stock is taken, has fallen from just over 10% in June 2011 to just about 7% in this year June.

A derivative is a financial product that gets its value from an underlying asset. Futures and options (F&O) are common derivatives, though there is a big list of other sophisticated ones too. While it is true that most of the business on the derivatives side comes from speculators, there is a small but growing brand of intrepid retail and high net worth investors (HNIs), who are using derivatives as a strategy to cut losses on direct stock investing.

What are hedging strategies?

Called hedging, strategies that use derivatives to protect the downside of an existing portfolio may not be very exciting in a range-bound market, which is the case currently, but in runaway markets (recall the rally in January-February 2012), such products may be useful. Anytime, as a stock investor, after you experience a sharp rally in the markets, may be a good time to use a hedging strategy against the risk of a sudden sharp market correction, keeping the profits intact. Says Siddharth Bhamre, head (derivatives), Angel Broking Ltd, “Hedging is not so popular because when the markets are rallying people don’t consider the risk of a fall and then panic after the markets are significantly down. The best time for a hedge is when there is too much positivity.” Flip this around: when there is negativity in the markets and they are trading lower, there is no need to hedge, you can simply buy equity.

Explains Sahaj Agrawal, associate vice-president (derivatives), Kotak Securities Ltd, “Think of it like you would of life insurance. This means you pay a cost to protect something and if an adverse event happens you benefit. If, however, things remain good, then you have to forgo the cost for no returns.” This means that to protect the value of your portfolio you will have to incur a cost, that is the premium of the option. If markets fall, your portfolio value is protected to the extent of your hedge. But if they don’t, all you lose is the premium. The cost of this premium is usually between 1% and 3% (for the option mentioned in this article) of the value of the portfolio. This premium will rise if the markets are volatile.

Caveats: Hedging is meant only for the strong hearted and seasoned equity investor. If you are an experienced equity investor with good discipline and sufficient surplus, then move towards derivatives. If you have built a portfolio in just the last two-three years, stick to simpler investment instruments such as mutual funds and stay with a disciplined asset allocation to hedge your risks. Says Pawan Joseph, vice-president, Motilal Oswal Wealth Management Ltd, “We advise clients to stick to long-term assets rather than derivatives. The idea is to give them products in line with their asset allocation objectives.”

Also See | How They Work (PDF)

Here are two hedging strategies that you can use to put a safety net under your direct equity portfolio.

Hedging strategies you can use

Buy an “at-the-money” put option: A put option gives the buyer the choice to sell the underlying security (in this case Nifty) at a pre-determined price known as the strike price. The option you need to buy is at the money one-month put option.

The term “at-the-money” means that the options’ strike price is the same as the current price of the underlying security. Today, this means a Nifty put option will have a strike value of 5,200 and the cost to buy this is currently around Rs 75. Keep in mind that while hedging, it is important to choose the security that has high volumes, so stick to the nearest one-month option. If you are starting a hedge now, you will be buying the August 5,200 put option. The number of options you buy will depend on your portfolio value.

Here is how it works: Let’s say you have a large-cap-oriented equity portfolio worth Rs 10 lakh, then you have to buy Nifty put options equal to the current market value of this portfolio. If the market moves above the strike price or the current value (since they are the same) you will not exercise the option and things remain as they are. Your portfolio value will increase with the market. If the market falls below the strike price, then the loss on your portfolio is compensated by the gains you make on the option. Your put option says you have the right to buy Nifty at 5,200, so the profit you make if, say, Nifty drops to 4,800 is simply 5,200 minus 4,800, or Rs 400 (see graph).

Short futures: For this hedge, you need to short-sell or sell shares first and buy them back later. You will have to maintain a margin of around 25% of the trade value with your broker and this can be in the form of stocks from your existing portfolio. In the practical transaction, you don’t actually buy back the shares or the index, rather just settle the difference. For example, if you short-sell Nifty futures at 5,200 and the market falls to 4,800, you gain because you have already sold Nifty at 5,200 and you can buy it at 4,800. Your gain is Rs 400 and the transaction gets closed when that amount is credited to your trading account. Similarly, if Nifty moves to 5,600, you lose Rs 400 and the transaction is closed by debiting your trading account with that amount, but the value of your existing portfolio rises.

Here is how it works: If you have a portfolio consisting of large-cap shares you can short- sell Nifty futures for a value equal to the value of your current portfolio. Unlike an option trade, this is a hedge where you lock in the upside. In other words, you simply protect the value of your portfolio from declining further, but don’t stand to gain anything (see graph).

This is what it means: If you are hedging your portfolio, you expect the market to correct a bit and that’s why you want to protect your profit. If the market moves up, the short position you have taken in the futures runs into a loss. You will see a negative payoff on that trade but keep in mind that your original equity portfolio will gain roughly an equal amount, thanks to the upmove and the loss on futures will cancel out the gains in the equity portfolio. The opposite happens if the market corrects; you lose on your equity portfolio and gain on the futures, thereby netting out the overall payoff. So this strategy helps you protect your current portfolio value as it is, but there are no gains. If the market has moved up and you incur a loss on the futures trade, in the event that you don’t make good the loss from your gain on the other portfolio, the 25% margin with the broker will be used against the loss settlement.

lisa.b1@livemint.com