Basics of Hedging | How to do Hedging?

Hedging is a sophisticated risk management tactic that entails purchasing or disposing of a security to potentially help lower the risk of a position's potential loss.

 

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Individual investors do not frequently utilise hedging as a trading strategy, and when they do, it is typically done after the initial investment has been made.

In other words, you wouldn't hedge a position before you buy or sell a stock short.

To minimise potential losses for an existing deal if it moves against your expectations and in the opposite direction, that is the main reason to hedge.

Supposing you believe your trade will eventually move in the opposite way from where you want.

You could wish to hedge rather than close it out for a number of reasons, including:

Overconcentration: You may want to mitigate some of the risks associated with a certain investment (such as business stock) if you have a high exposure to it.

Tax repercussions: You might not want to sell a position in a way that triggers a taxable event.

The question now is: How do I hedge?

For instance:

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Consider purchasing 250 shares of Infosys at a cost of Rs. 2,284 each. This amounts to a Rs. 571,000 investment.

In the spot market, you are "Long" Infosys. You realise the quarterly results are due soon after starting this employment.

You worry that Infosys may release some unfavourable figures, which could cause the stock price to drop significantly.

You choose to hedge the position in order to prevent suffering a loss on the spot market.

We only need to enter a counter position in the futures market to hedge the spot position. We must "short" in the futures market because the spot position is "long" at this time.

Details of the short futures trade are as follows:

Short Futures @ 2285/-

Lot size = 250

Value of the Contract: Rs. 571,250

You are currently long Infosys (in the spot market), whereas we are short it (in the futures pricing), albeit at different prices.

The price variation is unimportant, though, because we are 'neutral' in terms of direction.

MITHILESH M.K.