How can you hedge your positions in Futures and Options?
You can gain decent returns on your investment within a very short period. While investing in the stock markets, you can either trade in the stocks of various companies or you can trade in derivatives, such as Futures and Options. Although futures trading is a risky, it may provide you with profits or incur losses also.
Futures trading also allows you to hedge against your active trading positions and prevent yourself from incurring high losses due to adverse market movements. Let’s learn what are Futures and Options and how they can help you hedge against your trading positions.
What are Futures and Options?
Futures and Options are stock market derivatives that allow you to buy or sell underlying securities at a pre-determined price on or before a pre-determined date in the future.
With Futures contracts, you get the right to mandatorily sell or buy underlying stocks at a pre-determined price on a specific date in the future. On the other hand, Options contracts give you the right but not the obligation to sell or buy underlying stocks at a specific price on or before a specific date, which is known as the expiry date of the contract.
What is Hedging?
One of the most crucial and useful applications of Futures and Options trading is hedging. Hedging essentially means to limit the risk of an asset or a portfolio. It involves buying one instrument and subsequently selling the other to offset the risk. In the case of adverse market movements, hedging enables you to protect your active trading positions from making big losses. This is similar to buying insurance against your car by paying a small premium amount. Let’s understand what hedging is with simple analogy?
Suppose you decide to create a beautiful little garden in front of your house. You plant several trees, nurture them daily and watch them grow into beautiful flowering plants. Eventually, your efforts start bearing fruits and your little garden starts to blossom with colourful flowers and lush green.
However, soon you notice that stray cows and animals are merrily grazing the lush green plants and beautiful flowers in your garden. What will you do in such a case? You will construct fencing around your garden to prevent stray animals from entering it.
Now let’s correlate this analogy to the stock markets and hedging:
- Suppose you’ve created a well-balanced portfolio by choosing a variety of stocks after careful analysis. This portfolio is equivalent to your little garden
- Now, at some point, the market enters a turbulent phase due to political unrest and the values of all your stocks fall drastically. This situation is equivalent to the stray cows grazing in your garden and spoiling its aesthetics.
- To prevent your trading positions from incurring losses at such turbulent times, you start hedging by taking opposite positions to offset the losses. This is equivalent to constructing a fence around your garden
Hope you’ve now got a fair idea of ‘hedging’ after studying this analogy. As mentioned earlier, hedging helps you to avoid substantial losses due to adverse market movements. Now, let’s understand how Futures and Options trading helps you to hedge against your active trading positions.
How you can hedge through Futures and Options?
With Futures and Options trading, you can use long (Buy) and short (Sell) hedges to reduce your upside and downside risks. When an investor takes a short position on a Futures contract and buys a Put Option, it is termed a short hedge. Short hedging is useful when an investor is expecting the value of the underlying stocks to decreases quickly.
So, if you have active buy trading positions of a specific stock, you can deploy hedging by taking a short position on a Futures contract or by buying a Put Option.
Similarly, if you have active short positions in a specific stock and when you take a long position on a Futures contract or buy a Call Option, it is termed a long hedge. Long hedging can help you mitigate your risks as the profit in one instrument is offset by loss in another.
In case the market moves upwards sharply, the value of your short trading positions will decrease. However, the value of your long position on a Futures contract or Call Option will start increasing, thereby reducing your overall losses.
Hedging against your active trading positions through Futures and Options can help you mitigate your overall risks and minimise your losses in the case of adverse market movements. However, before buying a Futures or Options contract, you need to be aware of the risks attached to it. Remember, the goal of hedging is not to make profits but to protect yourself from incurring losses. So, you need to be diligent and careful while taking any fresh trading positions or hedging positions.
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