HEDGING STRATEGIES

HEDGING STRATEGIESWHAT IS HEDGING?Hedging is a mechanism to reduce price risk

Derivatives are widely used for hedging

Its main purpose is to reduce the volatility of a portfolio, by reducing risk

Hedging does not maximizes the return it just reduces the variation in the returnHEDGING STRATEGIESOne of the popular strategies for hedging is : "If you are long in cash underlying - Short Future; and If short in cash underlying - Long Future

For e.g. If one has bought 100 shares of say Reliance Industries and want to Hedge against market movements, he has to short an appropriate amount of Index Futures. This will reduce his overall exposure to events affecting the whole market

WHERE HEDGING STRATEGIES ARE USEFULReducing the equity exposure of a Mutual Fund by selling Index Futures

Investing funds raised by new schemes in Index Futures so that market exposure is immediately taken

Partial liquidation of portfolio by selling the index future instead of the actual shares where the cost of transaction is higherHEDGING STRATEGIES FOR INVESTORSHedging Strategy #1 Dedicated Short Bias

Hedging Strategy #2 Fixed Income Arbitrage

Hedging Strategy #3 - Market Timing

Hedging Strategy #4 Aggressive Growth

Hedging Strategy #5: Opportunistic

To hedge short underlying position with optionsBuy call

Sell put

Buy call spread

Sell put spread

Buy semi-futures

To hedge short underlying position with optionsAnticipantsCharacteristics Short call Implied volatility downLimited profit - Unlimited loss - Limited protection - Cash credit - Risk profile at expiration equivalent to a short putLong putImplied volatility upUnlimited profit - Limited loss - Unlimited protection - Important cost - Risk profile at expiration equivalent to a long callShort semi-futures Implied volatility direction depends on the strikes

Buy put and sell call with a higher strike

Limited profit - Limited loss - Unlimited protection - Low cost - Risk profile at expiration equivalent to a long fence or a bull spreadTo hedge short underlying position with optionsshort call spread or bull spread Implied volatility direction depends on the strikes: Sell call and buy call with higher strike

Unlimited profit - Unlimited loss - Limited protection - Low cost - Risk profile at expiration equivalent to a long semi-futures

Long put spread or bear spread Implied volatility direction depends on the strikes: Sell put and buy put with higher strike

Unlimited profit - Unlimited loss - Limited protection - Low cost - Risk profile at expiration equivalent to a long semi-futures

To hedge long underlying position with optionsSell call

Buy put

Sell call spread

Buy put spread

Sell semi-futuresTo hedge long underlying position with optionsAnticipates Characteristics Short callImplied volatility downLimited profit - Unlimited loss - Limited protection - Cash credit - Risk profile at expiration equivalent to a short putLong putImplied volatility upUnlimited profit - Limited loss - Unlimited protection - Important cost - Risk profile at expiration equivalent to a long callShort semi-futures Implied volatility direction depends on the strikes: Buy put and sell call with a higher strike

Limited profit - Limited loss - Unlimited protection - Low cost - Risk profile at expiration equivalent to a long fence or a bull spreadTo hedge long underlying position with optionsshort call spread or bull spread Implied volatility direction depends on the strikes: Sell call and buy call with higher strike

Unlimited profit - Unlimited loss - Limited protection - Low cost - Risk profile at expiration equivalent to a long semi-futures

Long put spread or bear spread Implied volatility direction depends on the strikes: Sell put and buy put with higher strikeUnlimited profit - Unlimited loss - Limited protection - Low cost - Risk profile at expiration equivalent to a long semi-futures