Most effective hedging strategies to reduce market risk
As the Nifty scales an all time high, there are two major imperatives in the market. Firstly, how do you ensue that you participate in stock specific stories in a secular bull market. After all, wealth creation is a long term story and the India consumption story is still one of the most compelling from an investor’s standpoint. The second imperative is to manage risk in the midst of volatile market conditions. This applies to domestic risk as well as global financial and geopolitical risk.
Why are we worried about risk, right now?
Risks in the financial markets have heightened for two specific reasons; one domestic and one global. Let us look at the domestic reason first. If you look at the VIX chart above, it clearly indicates that the volatility index has been consistently falling since the beginning of January 2017. While that is a sign of falling fear in the market, it also has a downside. The VIX is currently close to its normal cyclical lows and a bounce in VIX could make the markets more volatile. Nifty normally tends to be negatively correlated with the VIX and the current level makes a strong case for hedging risk. The second reason is global risk. The missile attacks by the US in Syria and Afghanistan has revived fears of geopolitical tensions simmering. Closer in Asia, North Korea is becoming a cause of tensions in the South China Sea and that could trigger a correction in markets any time. Additionally, key European economies like France and UK could be in for a period of political turmoil as equations could be changing. All these add to volatility and could be a base case for hedging downside risk. How exactly to go about hedging your portfolio risk at these levels? Get to know more about online Stock Market overview
Hedging risk using Index Futures
Selling index futures against your portfolio holdings is the simplest way of hedging your risk. Here is how it works. Assume that you have an equity portfolio of Rs.50 lakhs. The value of 1 lot of Nifty is approx Rs.6.85 lakhs at current levels and you can hedge your portfolio by selling 7 lots (525 Nifty units) of Nifty futures. Remember, your portfolio may not be perfectly correlated with the Nifty so this is not the perfect hedge. But the idea here is to protect downside risk in the event of any external disruptions to your portfolio. Having sold Nifty futures, there are two scenarios that are possible. Firstly, the Nifty may move up from current levels. That will lead to losses on Nifty Futures (since you have sold Nifty futures), but the value of your equity portfolio will have most likely gone up.
Alternatively, let us assume that the US and Russia come to loggerheads over North Korea and Nifty corrects by 4% in a single day. Obviously, the value of your stock portfolio will be down. But, since you have sold Nifty Futures, you will make a neat profit on Nifty Futures. Thus your hedge not only protects, but also helps you profit from the volatility.
You can also hedge your risk using Index Put options
Put Options are slightly different from futures in that they represent a “right to sell, but not an obligation to sell”. When you buy put options on the Nifty, you get a right to sell the Nifty but not an obligation to sell the Nifty. For this privilege you have to pay a small price which is called the option premium. Let us go back to the case of the Rs.50 lakh portfolio. As we are already in the last week of April (derivatives expire on the last Thursday of each month), we will buy May options instead. For an approximate hedge, one can buy 7 lots (525 Nifty units) of 9100 strike put options in the May series. This is currently available at a price of around Rs.90/unit. Thus the cost of buying 525 Nifty units will be Rs.47,250/- (525x90). On a portfolio value of Rs.50 lakhs, this translates into a 1-month cost of 1%. That is where you need to make a trade-off. Considering the current volatility, if you can protect your portfolio from 5% volatility, then a cost of 1% is surely worth it.
Simpler still; buy gold to hedge against uncertainty
This may not be a very scientific way of hedging your portfolio, but it will work nevertheless. Remember, gold is a safe-haven investment. That means, in times of geopolitical risk gold is in demand and therefore you will see a rise in the price of gold. We saw that in the midst of the economic uncertainty in early 2016 when gold rallied by over 25% in less than 6 months. The notional loss in equity can be partially compensated by shifting a part of your equity portfolio into gold (prefer non-physical gold). This will not only save you from the volatility, but will also help you profit from gold and use the liquidity to buy back equities at lower prices. A very important consideration in this strategy will be the tax. There will be a tax implication when you churn equities and also when you churn gold. You need to factor that before evaluating the efficacy of this strategy.
There are also other ways to diversify your risk in volatile times. One can also hold more of defensive sectors instead of high-beta sectors. One can also look at debt as an option to reduce the volatility. The moral of the story is that investors need to seriously look at ways and means of managing their portfolio risk and volatility at these levels. That is a must!
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