Have you ever felt that a stock was intrinsically undervalued?
That the profits and the quality of the company made it worth a lot more as compared with what the market thinks? Have you ever been a “stockpicker” and carefully purchased a stock based on a sense that it was worth more than the market price?
A person who feels like this takes a long position on the cash market. When doing this, he faces two kinds of risks:
1. His understanding can be wrong, and the company is really not worth more than the market price; or,
2. The entire market moves against him and generates losses even though the underlying idea was correct.
The second outcome happens all the time. A person may buy Infosys at Rs.190 thinking that it would announce good results and the stock price would rise. A few days later, Nifty drops, so he makes losses, even if his understanding of Infosys was correct.
There is a peculiar problem here. Every buy position on a stock is simultaneously a buy position on Nifty. This is because a LONG INFOSYS position generally gains if Nifty rises and generally loses if Nifty drops.
The stock picker may be thinking he wants to be LONG INFOSYS, but a long position on Reliance effectively forces him to be LONG INFOSYS + LONG NIFTY.
It is useful to ask: does the person feel bullish about INFOSYS or about the index?
• Those who are bullish about the index should just buy Nifty futures; they need not trade individual stocks.
• Those who are bullish about INFOSYS do wrong by carrying along a long position on Nifty as well.
There is a simple way out. Every time you adopt a long position on a stock, you should sell some amount of Nifty futures. This offsets the hidden Nifty exposure that is inside every long–stock position. Once this is done, you will have a position, which is purely about the performance of the stock. The position LONG INFOSYS + SHORT NIFTY is a pure play on the value of INFOSYS, without any extra risk from fluctuations of the market index. When this is done, the stockpicker has “hedged away” his index exposure.
Warning: Hedging does not remove losses. The best that can be achieved using hedging is the removal of unwanted exposure, i.e. unnecessary risk. The hedged position will make less profits than the un-hedged position, half the time. One should not enter into a hedging strategy hoping to make excess profits for sure; all that can come out of hedging is reduced risk.
How do we actually do this?
1. We need to know the “beta” of the stock, i.e. the average impact of a 1% move in Nifty upon the stock. If betas are not known, it is generally safe to assume the beta is 1. Suppose we take WIPRO, whose beta is 1.2, and suppose we have a LONG WIPRO position of Rs.200,000.
2. The size of the position that we need on the index futures market, to completely remove the hidden Nifty exposure, is 1.2 *œ200,000, i.e. Rs.240,000.
3. Suppose Nifty is at 1200, and the market lot on the futures market is 200. Hence each market lot of Nifty is Rs.240,000. To sell Rs.240,000 of Nifty we need to sell one market lot.
4. We sell one market lot of Nifty (200 nifties) to get the position:
LONG WIPRO Rs.200,000, SHORT WIPRO Rs.240,000
This position will be essentially immune to fluctuations of Nifty. The profits/losses position will fully reflect price changes intrinsic to WIPRO, hence only successful forecasts about WIPRO will benefit from this position. Returns on the position will be roughly neutral to movements of Nifty.
That the profits and the quality of the company made it worth a lot more as compared with what the market thinks? Have you ever been a “stockpicker” and carefully purchased a stock based on a sense that it was worth more than the market price?
A person who feels like this takes a long position on the cash market. When doing this, he faces two kinds of risks:
1. His understanding can be wrong, and the company is really not worth more than the market price; or,
2. The entire market moves against him and generates losses even though the underlying idea was correct.
The second outcome happens all the time. A person may buy Infosys at Rs.190 thinking that it would announce good results and the stock price would rise. A few days later, Nifty drops, so he makes losses, even if his understanding of Infosys was correct.
There is a peculiar problem here. Every buy position on a stock is simultaneously a buy position on Nifty. This is because a LONG INFOSYS position generally gains if Nifty rises and generally loses if Nifty drops.
The stock picker may be thinking he wants to be LONG INFOSYS, but a long position on Reliance effectively forces him to be LONG INFOSYS + LONG NIFTY.
It is useful to ask: does the person feel bullish about INFOSYS or about the index?
• Those who are bullish about the index should just buy Nifty futures; they need not trade individual stocks.
• Those who are bullish about INFOSYS do wrong by carrying along a long position on Nifty as well.
There is a simple way out. Every time you adopt a long position on a stock, you should sell some amount of Nifty futures. This offsets the hidden Nifty exposure that is inside every long–stock position. Once this is done, you will have a position, which is purely about the performance of the stock. The position LONG INFOSYS + SHORT NIFTY is a pure play on the value of INFOSYS, without any extra risk from fluctuations of the market index. When this is done, the stockpicker has “hedged away” his index exposure.
Warning: Hedging does not remove losses. The best that can be achieved using hedging is the removal of unwanted exposure, i.e. unnecessary risk. The hedged position will make less profits than the un-hedged position, half the time. One should not enter into a hedging strategy hoping to make excess profits for sure; all that can come out of hedging is reduced risk.
How do we actually do this?
1. We need to know the “beta” of the stock, i.e. the average impact of a 1% move in Nifty upon the stock. If betas are not known, it is generally safe to assume the beta is 1. Suppose we take WIPRO, whose beta is 1.2, and suppose we have a LONG WIPRO position of Rs.200,000.
2. The size of the position that we need on the index futures market, to completely remove the hidden Nifty exposure, is 1.2 *œ200,000, i.e. Rs.240,000.
3. Suppose Nifty is at 1200, and the market lot on the futures market is 200. Hence each market lot of Nifty is Rs.240,000. To sell Rs.240,000 of Nifty we need to sell one market lot.
4. We sell one market lot of Nifty (200 nifties) to get the position:
LONG WIPRO Rs.200,000, SHORT WIPRO Rs.240,000
This position will be essentially immune to fluctuations of Nifty. The profits/losses position will fully reflect price changes intrinsic to WIPRO, hence only successful forecasts about WIPRO will benefit from this position. Returns on the position will be roughly neutral to movements of Nifty.