Hedging Trading Risks. Stock Markets are never stable. They are either rising, falling or moving within a range. The markets are unpredictable. There is every possibility that your expectations may go wrong. If it goes wrong then you stand to make a loss. One way is to have proper stop losses in place so that your losses are limited. But there is another way to insure yourself against such unexpected behaviour of the market. Hedging trade risks using put options and call options.
Those who trade in stocks try to predict in what direction the market will flow and decide to trade in that direction. If they expect the markets to rise then they buy stocks or go long on futures. If they expect the markets to fall then they go short on futures. Buying futures contracts is called as long position and selling futures contract is called short position. In futures you don’t need to hold the stocks for selling them because you are dealing in contracts whose underlying is the stock.
Let us take an example:
You expect the price of BHEL shares to rise. You enter into one futures contract expiring in September, 09 to buy 150 BHEL shares. 150 being the market lot in which BHEL is traded at a price of Rs.2280. The total margin for this trade will be Rs. 58500
If the prices go up as expected by you then you stand to make a profit. If they go against your expectation and fall then you stand to make a loss. In order to play safe you can hedge your risks using Options. You can buy put options. You can buy the following put option.
BHEL put options, one lot of 150 shares at a strike price of Rs.2280 expiring in September, 09. The premium is Rs.52 for one share. The total premium payable will be Rs. 7800/-
Your total investment is
Margin for future contract ------------- 58500
Premium for put options ---------------- 7800
Total --------------------------------------- 66300
Scenario 1:
On the expiry date if the price of BHEL has gone up as expected by you and the prices reach Rs. 2380 you will make a net profit as follows:
(Selling price – purchase price) * 150 shares = (2380 – 2280) * 150 ---------- 15000
Less premium for put options ---------------------------------------------------------- 7800
Net profit ---------------------------------------------------------------------------------- 7200
Scenario 2:
On the expiry date if the price of BHEL goes against your expectation and the price falls to Rs.2180 you will make a loss.
(Selling price – purchase price) * 150 shares =(2180 – 2280) * 150 --------- 15000 (loss)
Add premium for put options ------------------------------------------------------- 7800
Total Loss ------------------------------------------------------------------------------ 22800
Profit on squaring options on expiry ----------------------------------------------- 15000
Net loss -------------------------------------------------------------------------------- 7800
If put options were not bought and hedging was not done then the total loss would have been Rs.15000/- On account of the put option the maximum loss is pegged at Rs.7800 which is the premium paid for the put option. Your loss can never exceed this premium amount. The chances of making profit on the futures contract are unlimited.
