What do we understand by the term hedging? Essentially, hedging is about protection of your risk. When you buy shares you stand the risk of notional loss when the prices go down. If you buy shares and the stock price goes down what are your options? Basically, you have 3 options in front of you..
You can just hold on to your position since you are a long term investor and are therefore not bothered about price volatility
You can exit the stock and wait for the next trigger in the stock to decide whether to buy back or not
You can hedge your risk on the stock by either selling the futures on the stock or by buying put options.
Here let us focus on hedging with stock futures or with stock index futures. Hedging with stock index futures and with stock futures entails a cost in terms of margin money locked in. But it gives protection in the event of a downside. How to hedge using stock index futures and stock futures? Let us understand this concept with some hedging with futures examples.
Broadly, there are 3 situations when there is merit in hedging using stock futures
Hedging when the stock price goes down
Here you hedge your cash market position when the stock price goes down. Let us say you bought SBI at Rs.320. Since you are a long term investor you have not really bothered about a stop loss. But now the stock price of SBI has come down to Rs.305 and you are worried as your chartist has warned that the stock could fall further to Rs.270 levels. What you can do is to sell the SBI futures at Rs.305. By doing so you lock in a maximum loss of Rs.15. This way you are totally immune when the price goes down below Rs.305. Below that point, whatever is your notional loss on your cash market position is compensated by profit on your short SBI futures. There are 2 possible situations here..
Situation 1: The stock price of SBI corrects to Rs.270, which is the support that your chartist has advised. At this level you close your short futures position and book the profit of Rs.35 on the short futures position. Now your futures on SBI is closed and your average cost of SBI cash position has come down to Rs.285. That is surely a more comfortable position for you to be in and that is thanks to the power of hedging.
Situation 2: The stock of SBI bounces back from 305. Then what do you do because you are now incurring losses on your short futures position. Then you need to identify the next resistance level of SBI on the upper side. Let us assume that the next resistance is Rs.330. If this level is breached with volumes you book losses of Rs.25 on your futures position and close out. But you are making a notional profit of Rs.10 on your cash market position so your net loss is still capped at Rs.15. But since you have already booked a loss of Rs.25 on your futures position your break even cost of the cash market position goes up to Rs.345. This decision should only be taken after a resistance is effectively breached. The substance of this position is that you have capped your loss at Rs.15.
Hedging when you expect volatility
The second reason to hedge is when you anticipate market to become volatile ahead of key events like Union Budget, monetary policy, US Fed meetings, OPEC meetings etc. In these situations it is always better to remain hedged as you do not know how the stock price will react. There could be a hedging cost but it is safer to be hedged. In case you have a portfolio of stocks you can also look at hedging using the index futures rather than stock futures.
Hedging to protect your profits
This is a unique kind of hedging where you use hedging with stock futures to protect your profit. Let us assume that the day after you bought SBI at Rs.320, the government announced a major bank recapitalization program. Therefore in the next 3 days, the stock went up to Rs.375. One option is to book your profits at Rs.375 and exit SBI. But, now due to the positive news flows your broker expects the stock to reach up to Rs.450 in the next 3 months. You can hedge your profits by selling SBI Futures at Rs.375. That way you lock in the profits of Rs.55. This profit is assured irrespective of where the stock moves from here. If the stock of SBI crosses another resistance, then you can again look to shifting the futures to the next month. This is also the equivalent of a trailing stop loss in profitable situation.
Of course, hedging using stock futures is meaningful when you are looking at individual stocks. When you are looking at portfolios, then hedging with index futures using beta hedging is more meaningful.