What Is Hedging with Futures and How Does It Work?
Adverse market movements may take a toll on your investment portfolio. However, there is a way to safeguard your portfolio and limit the risk associated with an asset. Hedging can help you retain your market position and protect your investments from significant losses.
Hedging with futures contracts works on the same principle as insuring a car or your home. Using futures, you invest in an asset that will move in the opposite direction to your core investments. So, when your core investment incurs losses, the other investment will offset it.
Before we start discussing how hedging with futures works, let us understand futures contracts and hedging.
What Are Futures?
Futures are a type of financial contract that allows an individual to buy or sell an underlying asset at a predetermined rate and date in the future. These underlying assets can be stocks, commodities, currencies or indices.
A futures contract is an agreement between a seller and a buyer. The buyer agrees to buy a derivative at a specified time in the future as per the price mentioned in the contract. Each futures contract specifies the quantity, quality, date of delivery, and price at which the asset will be bought or sold.
The agreed price at the time of delivery is considered an exercise price. Furthermore, both the seller and buyer must honour the contract.
How Does Future Trading Work?
Futures trading is carried via recognised stock exchanges like the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE). Here, the broker allows traders and investors to speculate on the market’s future direction or a particular stock. Futures trading is one of the most common ways to hedge financial portfolios.
To start trading in futures, you will need to have a trading account. Before opening such an account, make sure to check the applicable fees levied by the broker and the quality of their services. Another thing to know about futures trading is that you need to deposit some margin money as security for your trades.
To make things more clear, keep reading the sections below.
What Is Hedging?
Hedging is the process through which an individual locks their market position by implementing certain tactics to counter adverse market movements. Hedging using futures is a market strategy where one can neutralise their profits or loss by predetermining market directions. Here, a certain number of shares are traded to offset the market impact on an existing trade of shares.
Continue following the next section to understand hedging with futures with an example
How Are Futures Used for Hedging?– With Example
So how do individuals use futures trading to hedge their portfolios? Let us understand it with an example.
Rajesh owns 100 shares of company XYZ, which he bought at ₹10 per share. Although the share prices of company XYZ were appreciating, Rajesh was concerned that the prices were soon going to drop.
Now remember that Rajesh was in a “long” position; that is, he would benefit from a positive price movement. However, to counter an adverse market momentum, Rajesh has to “short”, that is bet for a negative or downward market direction.
Therefore, Rajesh shorted his position in the futures market for 50 shares each worth ₹11. This way, he determined that the share price of XYZ company after a certain period could be ₹11. Subsequently, a broker issued a contract between Rajesh and a buyer. This way Rajesh locked his position at ₹11. Now let us look at some consequences.
|Prevailing Market Price During Contract Expiry||Long Spot on Existing 50 Shares||Short Spot on the 50 Shares Invested in Futures Trading||Overall Profit or Loss|
|₹6||(₹6-₹10)x50 = -₹200||(₹11-₹6)x50 = ₹250||₹250-₹200 = ₹50|
|₹10||(₹10-₹10)x50 = 0||(₹11-₹10)x50 = ₹50||₹50-0 = ₹50|
|₹14||(₹14-₹10)x50 = ₹200||(₹11-₹14)x50 = -₹150||₹200-₹150 = ₹50|
Therefore, as you can see, Rajesh was able to limit his risks in all 3 market scenarios, as the market value of the stock depreciated, appreciated and remained unchanged. This was only possible because Rajesh hedged the same number of shares via futures as the lot size used in share investment.
Points to Consider When Hedging with Futures
Here are some essential points that you should keep in mind while using futures to hedge your portfolio
- Distribute shares in the long and short positions equally to counter market trends.
- Diversifying your portfolio by investing in multiple companies reduces unsystematic risks like management misconduct, declining revenue, high leverage, declining profit margin, etc.
- Hedging your portfolio reduces systematic risks from inflation, fiscal deficit, downfall in Gross Domestic Product (GDP), etc.
- As per a SEBI circular released in 2018, stock derivatives can only be settled via physical delivery of stocks to the buyer’s Demat account.
- Index options such as Nifty, Bank Nifty, FinNifty, etc., are only settled with cash.
- Both parties are obliged to abide by the agreement at the end of the expiry of the futures contract.
- Both sellers and buyers will have to pay a margin to respective brokers till the contract expires.
- One does not have to hold on to a futures contract till the expiry. In case a futures contract is settled before expiry, the total profits or losses are adjusted against the margin deposited till the date of exit.
- The futures contract will automatically expire on the last Thursday of the expiry month. In that case, the overall profit or loss will be adjusted from the margin account.
- Futures trading is subject to brokerage and other statutory charges.
Overall, hedging can benefit traders and buyers to make the most out of their asset portfolio. However, it requires in-depth knowledge of futures trading and how it can help to protect your portfolio from market momentums. If you are not willing to participate in adverse market scenarios, futures trading can cater to an excellent means to hedge your portfolio.
Frequently Asked Questions
What is the expiry date for futures contracts?
The last Thursday of each month is the expiry date for a futures contract. In case, there is a holiday on that day, then the last Wednesday of the month can be considered the expiry date.
Can I square off futures before the expiration date?
Yes, paying the applicable charges can exit a contract before the expiry date. Furthermore, your profits and losses will be adjusted against your margin account.
What is the major difference between futures and options?
One of the major differences between futures and options is that, in futures, both seller and buyer have to oblige to the contract agreement. In contrast, the obligations are exempted in options trading.
What is the lot size to invest in futures trading?
The minimum lot size to invest in futures trading is ₹5 lakh.