9Introduction-Hedging Hedging reduces risk.Hedging involves establishing other position whose price behavior will likely offset the price behavior of the original portfolio.The objective of portfolio protection is the temporary removal of some or all the market risk associated with a portfolio.
10Using Options Equity options with a stock future Index options ( Nifty)Importance of deltaProtective putsWriting covered calls
11Importance of Delta/Beta Delta is a measure of the sensitivity of the price of an option to changes in the price of the underlying asset:Importance of DeltaDelta enables the to figure out the number of option contracts necessary to mimic the returns of the underlying security.Beta measures how much a stock would rise or fall if the market rises / falls. The market is indicated by the index, say Nifty 50.
12Example- Hedging using index Investor Buy 1000 shares of 800(approximate portfolio value of Rs. 8,00,000. However, the investor fears that the market will fall and thus needs to hedge.January Nifty futures is trading 6150The beta of Reliance is 1.25To hedge, the investor needs to sell [Rs. 8,00,000 *1.25] = Rs. 10,00,000 worth of Nifty futures(10,00,000/6150 = 162 Nifty Futures) 3 lotsWarning: Hedging involves costs and the outcome may not always be favorable if prices move in the reverse direction.
13Example- Hedging by Selling Stock Futures and Buying in Spot market Investor Buy 1000 shares of 800(approximate portfolio value of Rs. 8,00,000. However, the investor fears that the market will fall and thus needs to hedge.The Reliance futures (near month) trades at Rs. 806.To hedge, the investor will have to sell 1000 Reliance futures.Warning: Hedging involves costs and the outcome may not always be favorable if prices move in the reverse direction.
14Example- Hedging by buying Put option Investor Buy 1000 shares of 800(approximate portfolio value of Rs. 8,00,000. However, the investor fears that the market will fall and thus needs to hedge.Stock delta is always 1ATM put delta is always 0.50To hedge, the investor will have to buy 2000 Reliance 800 strike put option.Warning: Hedging involves costs and the outcome may not always be favorable if prices move in the reverse direction.
15Protective PutsA protective put is a long stock position combined with a long put positionProtective puts are useful if someone:Owns stock and does not want to sell itExpects a decline in the value of the stock
16Writing Covered CallsAppropriate when an investor owns the stock, does not want to sell it, and expects a decline in the stock priceAn imperfect form of portfolio protectionThe premium received means no cash loss occurs until the stock price falls below the current price minus the premium received
17Index Options Investors buying index put options: Want to protect themselves against an overall decline in the marketWant to protect a long position in the stockIf an investor has a long position in stock:The number of puts needed to hedge is determined via delta.
18DifferencesProtective puts provide protection against large price declines, whereas covered calls provide only limited downside protection. Covered calls bring in the option premium, while the protective put requires a cash outlay.
19Hedging Pre-requisites Identify the risksDistinguish between hedging and speculatingEvaluate the costs of hedging in light of the costs of not hedgingWhat is our objective?Should we hedge at all?If so, how much should we hedge?What hedging instruments should we use (Futures, Options)What tenor should we hedge (1 months, 3 months, etc.)?
20OBJECTIVE STRATEGY EXECUTION MONITORING REPORTING Should we hedge? When to hedge?Which instrument to hedge?How a hedge would perform under different market conditions?Further adjustmentWhat is the actual MTM for accounting purposes?
21Benefits of Hedging Mitigate - price risk Safeguard - Profit Margins Helps in making forecasting decisions, which are well supported by rational statistical analysisProvide confidence that the company has a well disciplined process to manage market uncertainties
22Recommended Books on Options/Technical Analysis “McMillan on Options” by Lawrence G. McMillan“Bible of Option Strategy” by Guy Cohen“Technical Analysis” by Charles D. Kirkpatrick II“Technical Analysis Of The Financial Markets” by John Murphy