Have you ever experienced the feeling of owning an equity portfolio, and then, one day, becoming uncomfortable about the overall stock market? Sometimes, you may have a view that stock prices will fall in the near future.
At other times, you may see that the market is in for a few days or weeks of massive volatility, and you do not have an appetite for this kind of volatility. The union budget is a common and reliable source of such volatility: market volatility is always enhanced for one week before and two weeks after a budget. Many investors simply do not want the fluctuations of these three weeks.
This is particularly a problem if you expect to need to sell shares in the near future, for example, in order to finance a purchase of a house. This planning can go wrong if by the time you sell shares, Nifty has dropped sharply.
When you have such anxieties, there are two alternatives:
1 Sell shares immediately. This sentiment generates “panic selling” which is rarely optimal for the investor.
2 Do nothing, i.e. suffer the pain of the volatility. This leads to political pressures for government to “do something” when stock prices fall.
In addition, with the index futures market, a third and remarkable alternative becomes available:
3 Remove your exposure to index fluctuations temporarily using index futures. This allows rapid response to market conditions, without “panic selling” of shares. It allows an investor to be in control of his risk, instead of doing nothing and suffering the risk.
The idea here is quite simple. Every portfolio contains a hidden index exposure. This statement is true for all portfolios, whether a portfolio is composed of index stocks or not.
In the case of portfolios, most of the portfolio risk is accounted for by index fluctuations (unlike individual stocks, where only 30–60% of the stock risk is accounted for by index fluctuations). Hence a position LONG PORTFOLIO + SHORT NIFTY can often become one–tenth as risky as the LONG PORTFOLIO position!
Suppose we have a portfolio of Rs.1 million which has a beta of 1.25. Then a complete hedge is obtained by selling Rs.1.25 million of Nifty futures.
Warning: Hedging does not always make money. The best that can be achieved using hedging is the removal of unwanted exposure, i.e. unnecessary risk.
The hedged position will make less profit than the unhedged 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.
The investor should adopt this strategy for the short periods of time where (a) the market volatility that he anticipates makes him uncomfortable, or (b) when his financial planning involves selling shares at a future date and would be affected if Nifty drops.
It does not make sense to use this strategy for long periods of time – if a two–year hedging is desired, it is better to sell the shares, invest the proceeds, and buy back shares after two years. This strategy makes the most sense for rapid adjustments.
Another important choice for the investor is the degree of hedging. Complete hedging eliminates all risk of gain or loss. Sometimes the investor may be willing to tolerate some risk of loss so as to hang on to some risk of gain. In that case, partial hedging is appropriate.
The complete hedge may require selling Rs.3 million of the futures, but the investor may choose to only sell Rs.2 million of the futures. In this case, two–thirds of his portfolio is hedged and one–third ofthe portfolio is held unhedged. The exact degree of hedging chosen depends upon the appetite for risk that the investor has.
At other times, you may see that the market is in for a few days or weeks of massive volatility, and you do not have an appetite for this kind of volatility. The union budget is a common and reliable source of such volatility: market volatility is always enhanced for one week before and two weeks after a budget. Many investors simply do not want the fluctuations of these three weeks.
This is particularly a problem if you expect to need to sell shares in the near future, for example, in order to finance a purchase of a house. This planning can go wrong if by the time you sell shares, Nifty has dropped sharply.
When you have such anxieties, there are two alternatives:
1 Sell shares immediately. This sentiment generates “panic selling” which is rarely optimal for the investor.
2 Do nothing, i.e. suffer the pain of the volatility. This leads to political pressures for government to “do something” when stock prices fall.
In addition, with the index futures market, a third and remarkable alternative becomes available:
3 Remove your exposure to index fluctuations temporarily using index futures. This allows rapid response to market conditions, without “panic selling” of shares. It allows an investor to be in control of his risk, instead of doing nothing and suffering the risk.
The idea here is quite simple. Every portfolio contains a hidden index exposure. This statement is true for all portfolios, whether a portfolio is composed of index stocks or not.
In the case of portfolios, most of the portfolio risk is accounted for by index fluctuations (unlike individual stocks, where only 30–60% of the stock risk is accounted for by index fluctuations). Hence a position LONG PORTFOLIO + SHORT NIFTY can often become one–tenth as risky as the LONG PORTFOLIO position!
Suppose we have a portfolio of Rs.1 million which has a beta of 1.25. Then a complete hedge is obtained by selling Rs.1.25 million of Nifty futures.
Warning: Hedging does not always make money. The best that can be achieved using hedging is the removal of unwanted exposure, i.e. unnecessary risk.
The hedged position will make less profit than the unhedged 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.
The investor should adopt this strategy for the short periods of time where (a) the market volatility that he anticipates makes him uncomfortable, or (b) when his financial planning involves selling shares at a future date and would be affected if Nifty drops.
It does not make sense to use this strategy for long periods of time – if a two–year hedging is desired, it is better to sell the shares, invest the proceeds, and buy back shares after two years. This strategy makes the most sense for rapid adjustments.
Another important choice for the investor is the degree of hedging. Complete hedging eliminates all risk of gain or loss. Sometimes the investor may be willing to tolerate some risk of loss so as to hang on to some risk of gain. In that case, partial hedging is appropriate.
The complete hedge may require selling Rs.3 million of the futures, but the investor may choose to only sell Rs.2 million of the futures. In this case, two–thirds of his portfolio is hedged and one–third ofthe portfolio is held unhedged. The exact degree of hedging chosen depends upon the appetite for risk that the investor has.