Strong Cushion to Portfolio by Hedging

STRONG CUSHION TO PORTFOLIO HEDGING

Strong Cushion to Portfolio by Hedging :

Introduction :
In this article we are going discuss, understand and learn about Hedging.
What is Hedging? Why Hedging is important for portfolio?

What is Hedging?
Hedging is a financial tool or instrument to protect our portfolio from loss due to volatile moment of market by the use of proper strategy.

In very simple language in winter season we wear sweater to protect ourself from cold of winter.
In summer season we wear cap, light color and cotton clothes to protect ourself from heat of summer.
This are our protection strategies against different weather to protect our body from different weather.

Similar way Hedging is a very effective mechanism to protect our invested money from market different up down movements.

Why Hedging is important for portfolio?
Now our portfolio consist of cluster of several share at a time. And if market start moving in reverse direction of our assumption. Then we have to suffer huge loss and our position get stucked. And in this situation if we found that there is very less chance of company financial condition revival for next upcoming few years. Then we have no option other than to move out of that company but as we already suffering loss than there is no chance to wind up the position at this point of time or situation. Then we have to set quite and also only able to see the other opportunities going out from our hand. At thus if our portfolio was Hedged than we can think to move out of that company in above narrated situation and take benefit of opportunities available. Loss is limited and decision making is easy even in our opposite condition.

How to do Hedging?
Generally Hedging is done in nearly every type of trading.
Agriculture
Equity
Future
Currency
Crude
Commodity etc

But we will discuss on Equity and FNO Hedging only.

Equity Hedging :
Suppose we expect Company ABC share are going to move upward in upcoming days. But market is volatile and movement is unpredictable. Then what we will do? We will make a portfolio of two or more stocks of same sector. Now next company is XYZ. Company ABC is strong and Company XYZ is weak company in same sector. We buy 100 shares of ABC at Rs.100 each and sell 50 shares of XYZ at Rs.50 each.

First day market up and ABC up by Rs.10 and XYZ up by Rs.5 then,
   ABC (100*10) - XYZ (50*5) =  Rs.750 Profit
Second day market down and ABC down by Rs.15 and XYZ down by Rs.10 then,
   ABC (100*(-15)) + XYZ (50*10) =  Rs.1000 Loss in place of Rs 1500

Equity Future Hedging :
Similar to Equity Hedging we can Hedge Equity with Future also.
Suppose we have bought Company ABC 5000 shares at Rs. 100 each then we have to pay Rs.5,00,000 and to buy a Future of Company ABC Future price running at Rs.103 a lot size is 5000 share we have to margin money nearly 30% ie about Rs.1,50,000.
But now we have bought equity and short or sold the Future against it. Means we have Hedged the combination of Equity and Future.
Please remember on Expiry the Equity and Future become equal means their is no difference of Premium or Discount on Expiry day with Equity price i.e spot price.

Then we have 3 situations, with Equity price Rs.100 and Future price Rs.103
If Equity move up by Rs.10 so Future will also move by Rs.7 to close at Rs.110, then on expiry
  Equity (5000*10) - Future (5000*7) = Rs.15000 Profit

If Equity move down by Rs.10 so Future will also move down by Rs.13 to close at Rs.90 , then on expiry
  Equity (5000*-10) + Future (5000*13) = Rs.15000 Profit

If Equity move by Rs.0 so Future will also move by Rs.0 to close at Rs.100, then on expiry
  Equity (5000*0) + Future (5000*3) = Rs.15000 Profit

This Hedging can be done with Future of current month with Future of next month also.

Conclusion :
So Hedging is very nice tool to protect our portfolio from very adverse impact of opposite direction move of market and balance it. It help to earn consist money step by step.

So Friends hope you understand the effect and importance of Hedging. All the best.

Disclaimer : This articles is only for knowledge and information sharing and not for any type of recommendation.