How to Hedge Your Portfolio in Market Crash

Introduction to Hedging

Hedging is a strategy employed to protect investments from market volaWhy Hedge Your Portfolio?tility. It involves taking an offsetting position in related securities to mitigate potential losses. This technique is especially useful during market corrections.

In this blog, we will explore the concept of hedging, its benefits, and various strategies to effectively hedge your portfolio using futures and options.

What is Hedging?

Hedging is akin to taking out insurance for your investments. When you buy a stock, you may fear that the market will decline, impacting your stock's value. Hedging helps minimize this risk by taking a position that offsets potential losses.

For example, if you own a stock and anticipate a market downturn, you can hedge your position by selling futures contracts. This way, any loss in the stock's value is offset by gains in the futures position.

Why Hedge Your Portfolio?

Investors hedge their portfolios for several reasons:

• Minimize losses
• Protect gains
• Reduce volatility
• Enhance risk management

Regardless of market conditions, hedging provides a cushion against adverse price movements.

Hedging Strategies

There are various strategies to hedge your portfolio. We will discuss two primary methods: hedging individual stocks and hedging the entire portfolio.

Hedging Individual Stocks

Let's say you bought a stock at ₹1,300 per share, investing ₹58,500 in total. If you anticipate a decline in the stock's value, you can hedge by taking a short position in the futures market.

For instance, if you own 45 shares of a stock priced at ₹1,300, you can sell futures contracts to offset potential losses. The contract size and value are crucial in determining the extent of hedging required.

Hedging the Entire Portfolio

To hedge an entire portfolio, you need to understand the concept of Beta. Beta measures a stock's volatility relative to the market. A portfolio with a high Beta is more sensitive to market movements.

For example, if your portfolio has a Beta of 1.8 and a total investment of ₹8,00,000, you can calculate the hedge value by multiplying the Beta by the total investment. This gives you a hedge value of ₹10,24,000.

Next, you can use Nifty futures to hedge the portfolio. Determine the number of contracts needed by dividing the hedge value by the contract value of Nifty futures.

Calculating Hedge Value

Let's break down the calculation:

1. Determine the portfolio Beta
2. Multiply Beta by total investment
3. Calculate the contract value of Nifty futures
4. Divide hedge value by contract value

For instance, if the Nifty futures contract value is ₹5,63,000, and the hedge value is ₹10,24,000, you need approximately 1.81 contracts. Since partial contracts are not possible, you can round up or down to the nearest whole number.

Example of Hedging

Consider a scenario where Nifty drops by 500 points:

• Portfolio Beta: 1.8
• Total Investment: ₹8,00,000
• Hedge Value: ₹10,24,000
• Nifty Futures Contract Value: ₹5,63,000
• Number of Contracts: 1.81 (rounded to 2)

If Nifty falls by 500 points, the profit from the short futures position offsets the loss in the portfolio, minimizing the overall impact.

Benefits of Hedging

Hedging offers several advantages:

• Reduces risk
• Protects against market downturns
• Enhances portfolio stability
• Provides peace of mind

By effectively hedging your portfolio, you can navigate market volatility with confidence.

Conclusion

Hedging is a powerful tool for investors looking to safeguard their portfolios from market fluctuations. Whether you are hedging individual stocks or the entire portfolio, understanding the mechanics and calculations involved is crucial.