0Definition: Hedging is the process to minimize the loss of trading / investment by creating a new position that can way off the effect of existing position.
We can not totally eliminate our loss but we can reduce it up to certain limit.
It is very popular among trader as well as investor during a big movement in the market or near by upcoming event.
Types of Hedge :
1. Long Hedge
2. Short Hedge
3. Cross Hedge
4. Complete Hedge
5. Partial Hedge
How it works :
- Hedging involves protecting an existing asset position from future adverse price
- movements. In order to hedge a position, a market player needs to take an equal and opposite position in the futures market to the one held in the cash market. Every portfolio has a hidden exposure to the index, which is denoted by the beta. Assuming you have a portfolio of Rs 1 million, which has a beta of 1.2, you can factor a complete hedge by selling Rs 1.2 mn of S&P CNX Nifty futures.
Steps:
- 1. Determine the beta of the portfolio. If the beta of any stock is not known, it is
safe to assume that it is 1.
- 2. Short sell the index in such a quantum that the gain on a unit decrease in the
index would offset the losses on the rest of his portfolio. This is achieved by
multiplying the relative volatility of the portfolio by the market value of his
holdings. Therefore in the above scenario we have to short sell 1.2 * 1 million =
1.2 million worth of Nifty
Why It Matters?
Hedging is like buying insurance. It is protection against unforeseen events, but investors usually hope they never have to use it. Portfolio hedging is an important technique to learn. Although the calculations can be complex, most investors find that even a reasonable approximation will deliver a satisfactory hedge. Hedging is especially helpful when an investor has experienced an extended period of gains and feels this increase might not be sustainable in the future. Like all investment strategies, hedging requires a little planning before executing a trade. However, the security that this strategy provides could make it well worth the time and effort.
