Futures are best used and applied when they are used to manage risk. Of course, you can also buy futures as a proxy for cash market positions but that is not the core purpose of using futures. Futures are most effective when they are used as a tool for hedging. The word hedging means protection. You not only protect your losses from increasing but you also protect your profits from reducing. That is the crux of hedging. So let us understand how to hedge stocks with futures and the hedging strategies using futures. Let us also look at hedging with futures examples..
Hedging by creating a cash-futures arbitrage..
This is the most common and passive form of hedge. Here you buy a stock in the cash market and sell equivalent futures. Remember, futures are sold in minimum lot sizes so you need to match your cash market position to the lot equivalents. Look at the illustration below..
On the trade dateAmount DetailsOn F&O Expiry dayAmount DetailsBuy 3000 shares SBIRs.259Sell 3000 shares SBIRs.285Sell 1 lot of SBI FuturesRs.261Buy 1 lot SBI FuturesRs.285Arbitrage SpreadRs.2Profit on SBI CashRs.26Arbitrage Yield (%)0.77% per monthLoss on SBI FuturesRs.24Annualized Yield (%)9.64%Net Profit on ArbitrageRs.2
The above arbitrage hedging becomes possible using futures because the cash and the futures price will close on the F&O expiry date at the same level. Thus the Rs.2 arbitrage spread that you have locked is realized. This translates into an annualized yield of 9.64% for the arbitrageur. However, in reality most arbitrageurs do not wait till expiry and if they get a sharp spread compression earlier they just reverse the trade and book the profits.
Hedging by locking in a profit position..
This is an interesting method of locking in your profits, especially when you expect the market to become volatile. For example assume that you have bought 2000 shares of Reliance one year back at Rs.650. After 1 year the stock has appreciated to Rs.950 due to the impact of the Reliance Jio launch. Obviously, that is a 46% return, which is a fantastic return in 1 year. Since you are a long term investor in RIL, you do not want to sell your cash position. Instead you can sell equivalent 2 lots of RIL futures at around Rs.955 (since futures normally quote at a premium). So the difference in price is locked in as your assured profit. Now even if you do nothing during the month your profit is assured. The added advantage in this position is that you can roll over the short futures each month and also earn the premium on short roll.
Hedging by locking in a loss on your position..
This is intended more towards protecting your losses beyond a point and hence the intent is more to protect your risk. Say, you purchased Tata Motors stock at Rs.370 but the stock suddenly fell to Rs.355 due to the trade war worries in China. What should you do..?
Loss making positionAmountWhen hedgedAmountBought TAMO1500 sharesSell 1 lot FuturesRs.358Buy PriceRs.370Loss locked inRs.12/shareCurrent Market PriceRs.355Roll prem. for 6 monthRs.9/shareNotional LossRs.22,500/-Reduced lossRs.3/share
This decision is very helpful especially when you expect some structural damage to the stock in the short term but you are confident in the long term. In the immediate term it makes sense to lock in your losses as in the above case. As you roll over each month and earn a premium, you automatically reduce your loss on the position. You can take a fresh view on the position subsequently. At lease your loss is capped for now!
Protecting risk using beta hedging..
The above 3 instances are perfectly understandable if you are talking about individual stock holdings. But what if you are holding on to a portfolio of stocks and you are worried about a global risk that could take the entire market down. The obvious answer will be to sell the Nifty futures. The question, then, is how much Nifty futures are to be sold so that your risk is fully hedged. That is where beta hedging comes into play. Let us understand how it works..
Portfolio DetailsAmountNumber of stocks in Mr. Sinha’s equity portfolio12 stocksCurrent Value of Equity Portfolio of Mr. SinhaRs.35,60,000 (A)Weighted Average Beta of the Portfolio1.18 (B)Nifty Futures to be sold for perfect hedge (AXB)Rs.42,00,800 (X)Market Lot size of Nifty75 unitsCurrent price of Nifty10,392Market value of 1 lot of NiftyRs.7,79,400 (Y)Number of Nifty lots to be sold for Beta hedge (X/Y)5.39 lots
Obviously you cannot sell 5.39 lots of Nifty so you will have to sell either 5 lots or 6 lots of Nifty depending on how aggressively you want to beta hedge. You may not get the perfect hedge but you much closer to comfort!