Hedging in terms of Future and options in Stock Market

Content Introduction- Futures and Options What is Stock Market Hedging- Using Future/Options Hedging Pre-requisites Strategies- Benefits of Hedging

Derivative Market Structure Stock Futures Stock options Call Options Put Option

Direction/ view/Trend of Market. (Up,Down,Sideways) Up Trend Down Trend Sideways Trend Four kind of Market Situation Bullish Market Bearish Market Volatile Market Sideways/Non volatile Market

Basic Strategies - Bullish Market Trading Strategy-HEDGING Take stock delivery Buy stock future Buy Call option Sell put option Bull call spread Ratio call spread Buy Put and buy future

Basic Strategies - Bearish Market Trading Strategy Sell stock future Buy Put option Sell Call option Bear Put spread Ratio Put spread Sell stock and buy Call

Basic Strategies- Volatile & Sideways Volatile Market Straddle Strangle Sideways Market Sell straddle Sell Strangle

Introduction-Hedging Portfolio protection :- Sell stock future Buy puts Buy Index puts Sell Nifty Futures

Introduction-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.

Using Options Equity options with a stock future Index options ( Nifty) Importance of delta Protective puts Writing covered calls

Importance 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 Delta Delta 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.

Example- Hedging using index Investor Buy 1000 shares of Reliance @ 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 6150 The beta of Reliance is 1.25 To 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 lots Warning: Hedging involves costs and the outcome may not always be favorable if prices move in the reverse direction.

Example- Hedging by Selling Stock Futures and Buying in Spot market Investor Buy 1000 shares of Reliance @ 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.

Example- Hedging by buying Put option Investor Buy 1000 shares of Reliance @ 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 1 ATM put delta is always 0.50 To 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.

Protective Puts A protective put is a long stock position combined with a long put position Protective puts are useful if someone: Owns stock and does not want to sell it Expects a decline in the value of the stock

Writing Covered Calls Appropriate when an investor owns the stock, does not want to sell it, and expects a decline in the stock price An imperfect form of portfolio protection The premium received means no cash loss occurs until the stock price falls below the current price minus the premium received

Index Options Investors buying index put options: Want to protect themselves against an overall decline in the market Want to protect a long position in the stock If an investor has a long position in stock: The number of puts needed to hedge is determined via delta.

Differences Protective 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.

Hedging Pre-requisites Identify the risks Distinguish between hedging and speculating Evaluate the costs of hedging in light of the costs of not hedging What 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.)?

OBJECTIVE STRATEGY EXECUTION MONITORING REPORTING Should we hedge? When to hedge? Which instrument to hedge? How a hedge would perform under different market conditions? Further adjustment What is the actual MTM for accounting purposes?

Benefits of Hedging Mitigate - price risk Safeguard - Profit Margins Helps in making forecasting decisions, which are well supported by rational statistical analysis Provide confidence that the company has a well disciplined process to manage market uncertainties

Recommended 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 www.theoptionsguide.com www.stockcharts.com/education/

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