How can Investors use Derivatives for Hedging?

How to use derivatives for Hedging: There is a common misconception amongst a lot of traders and investors that derivatives instruments, like futures and options are more suited for the purpose of trading and they have a minimal role in the world of Investing. 

But you would be surprised to know that, most of the big fund houses and fund managers and even the ace investors like Warren Buffet (and more) use Derivative products to hedge their long term view and improve their entry prices in the market.

Through this writeup, we will try and understand how investors can use Derivatives for Hedging?

What are Derivatives?

Derivatives as we are all familiar with are financial instruments that derive their value from the price of the underlying asset. The movement in the prices of the Derivative instrument is completely dependent upon the movement in the prices of the underlying asset. The most common form of derivatives instruments traded in the market are-

• Futures &
• Options

What are Futures?

A Futures contract is an obligatory contract to buy or sell the underlying at an agreed-upon price in the future. The Delta of a Futures contract is 1 i.e., for one rupee movement in the price of the underlying asset, there is one rupee change in the value of the futures contract attached to that underlying asset. They are sometimes also referred to as true hedging instruments.  

What are the Options?

Options are derivative instruments that give the buyer of the option the right to buy the underlying asset at a predetermined price upon the expiry. And the seller of the option is obligated to honour the terms of the contract upon expiry, if called upon. The most important points here are ‘the right of the buyer’ and ‘obligation of the seller’.

The difference lies in the premium factor. The buyer has the right, because he pays the premium to buy right on the underlying asset, and the seller is obligated as he is receiving the premium at the time of entering the contract. 

How to hedge using the Futures Contract?

There are generally two types of investors in the market – Active and Passive. A Passive investor is one who invests in the market and sits back and lets his investment play in the market.

On the other hand, an Active investor is one, who is on the constant lookout for opportunities to either earn short term benefits by taking some other position related to his investment or improve the entry price of his existing investments.

Having understood the concept of futures contracts, let us try and understand how one uses it as a hedging instrument in the world of investment.

Say, you are a long term investor in the shares of Reliance Industries and you are of the view that over the period of the next 5 years, the value of your investment is likely to double. 

But there is news running in the market that could pause the ascend (for short term) of the shares of Reliance Industries and there could be a possible correction of price to the tune of 3-5%.

Now, how does an investor benefit from this fall in the price? He is losing on the initial investment, but is it possible for him to gain from the price fall. The simple answer to this is “YES”. Let’s find out

Say

• The Initial buying Price = Rs. 2000
• Current Price of Reliance Industries = Rs. 2200
• Expected fall in price = 3-5%

The Active investor can short futures contract at Rs. 2200 (say) and if the price falls by 3%, then he would make a profit of

    = 3% of 2200

    = Rs. 66 per futures lot

So, he can improve his initial investment price of Reliance industries to Rs. 1934 (Rs. 2000 – Rs. 66). So this is the power of hedging which can benefit even the long term investors.

How to hedge using Options?

Just like the case of Futures contact, if you expect the price of an existing investment to fall, you can hedge it by buying a Put option (right to sell the underlying asset upon expiry).

So, if the price of the share falls down then you benefit by buying the put option and just in case the price does not decline, then all you stand to lose is the premium which was paid to buy the option contract.

Now, sometime it also happens that you want to buy certain share within curtain price band, but the price of that particular share is trading above (your desired level of buying), but you are fearful of the fact that the price might not come to your band and could go up from the current levels and you end up buying the shares at the existing price. Now how does one improve the entry price using options, let us find out how:

Say, the buy price of shares of XYZ limited – Rs. 510

Expectation form the market : Strength

So, one can write the Put option and pocket the premium and improve the initial entry.

Put option sold = 480 PE

Premium gained  = Rs. 4

And, if the Put Option expires worthless, then the premium received becomes our income and the entry price of Shares of XYZ limited will be

= Rs. (510 – 4)

= Rs. 506.

In Closing…

The derivatives instruments are not only tools of making gains from the short term investors. It can also be used by long term investors to gain from the price fall and also improve their point of entry. And with the new margin trading rules being imposed by SEBI, derivatives as hedging instruments have garnered a lot of attention. 

We hope you found this post interesting and learned quite a bit about Derivatives for Hedging. Please use the comment box below to share your opinions on the article “How to use derivatives for Hedging”.

Happy Investing and Money Making!!