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Here's how F&O traders can use hedging strategies to mitigate risk in equities

The article is an approach to understand some of the best option hedging strategies, that can help you manage your portfolio risk. The trade discussed here is of Buy stock and Buy Put.

SHUBHAM AGARWAL | 25-Sep-21
Reading Time: 3 minutes

Hedging is a risk management strategy employed to offset the losses in your existing asset by taking an opposite position in a related asset.

For the Indian equity and equity futures and options participants, this is generally simplified into a single transaction

Buy a Put Option against your Buy trade

As we all know Put option that costs premium has a characteristic that such premium rises in value if the stock or index that the option belongs to (underlying) falls. In case if its underlying rises Put option will fall.

This perfectly fits into the definition as a Buy trade will lose money if the underlying falls, the Put option will rise in value. One good thing about the Put option is that the maximum loss, in any case, is just the premium you pay to Buy the Put. This premium is just a tiny fraction of the value of underlying.

In other words, we can say the cost of this hedging is the Premium of the Put option. If we are ok with the cost, the Put option will make sure that we will not have any further loss. Some numbers can explain this even more clearly. Buy 1000 Stock X @ 100

Buy 1 lot (1000) 100 Put @ 5

Now if the stock goes down to 70, our loss on the stock would be 30. However, since we have the Put, where its premium will rise in such case, we would have an offsetting profit of a little less than 30, considering the cost we already paid.

On the other hand, if the stock goes up to 130, our profit on the stock would be 30, but the loss on Put will be just 5, as that is the premium we paid, which would go in vain.

Now, let us see how hedging is practised to manage risk.

#1 Initiate with Hedge

Here the offsetting position is entered into right at the time of initiation of trade.

When: Situations when we are in two minds about whether to take the trade-in first place. Initiate with Hedge takes away the unknown downside so even with low conviction in the view one can execute the trade with confidence.

#2 Repair with Hedge

This is the most used practice hedge. Here, one has already Bought and is Buying Put so that the existing position can be repaired, and no further loss occurs.

When: This is generally practised when one is very close to the stop loss level, a point beyond which taking loss will be unbearable economically. To prevent further loss without having to exit out of the Buy trade one Buys a Put to stop further loss by paying a cost (Premium).

A lot of Investors also resort to this practice in times of big events like results, policy decisions. Here the Put options are bought before the event and are sold after the event. In case of an unforeseen fall led by the event, those losses can be offset by the profit in Put.

#3 Lock Profits with Hedge

In this practice also Put option is bought some time after the Buy trade but after the Buy trade is already in profit.

When: After the trade goes into Profit and one is in the dilemma of booking profit or holding on for further gain. This is the time when one can Buy Put and lock the profit. This is done so that in case of a reversal there is no loss in profit (except the premium cost). The trade remains active if after a small pull back the stock starts rising.

These are some of the hedging practices that are used to make sure that the risk is well managed. As a result, by paying a certain cost (premium) one keeps trading without a negative surprise.

Before we conclude, it is customary to mention that hedging can reduce/ remove further loss, but it cannot undo a loss already incurred.

Also, the example trade mentioned was of Buy stock and Buy Put. However, the same hedging practices apply to a bearish trade where there is Sell Stock (majorly done in Futures) and Buy Call.

Learn and read more about candlesticks patterns from Quantsapp classroom which has been curated for understanding of what is dow theory from scratch, to enable option traders grasp the concepts practically and apply them in a data-driven trading approach.

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SHUBHAM AGARWAL is a CEO & Head of Research at Quantsapp Pvt. Ltd. He has been into many major kinds of market research and has been a programmer himself in Tens of programming languages. Earlier to the current position, Shubham has served for Motilal Oswal as Head of Quantitative, Technical & Derivatives Research and as a Technical Analyst at JM Financial.

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