Imagine you have recently bought a plush new Lamborghini. Now, it goes without saying that when a car is purchased, we also apply for its insurance, in case the car undergoes any damage due to an accident. The car insurance taken here comes to the rescue by bearing all the cost of the car damages that protects the car owner from spending a single rupee from their pocket. But to gain this benefit, the car owner has to pay some amount every month known as premium to get this insurance cover. The amount paid here is called hedging.
Since the car owner has hedged here by paying insurance, he can recover the entire amount of the car damages thereby, lowering the impactor risk on his savings. Let us dive deeper to know what is hedging and how does this work in the financial market.
What is hedging?
We are no stranger to the fact that the investments made in the stock market are on anticipation, which can be favourable or unfavourable sometimes. If the market works in the investor’s favour, profits will be delivered but, what if it gives losses? Similar to car insurance, hedging in stock markets acts as a safety net for protecting investments. Hedging is an investment status, which aims at decreasing the possible losses associated with an investment.
Where can hedging be done?
Hedging can be used in various investments such as commodities, which include things such as gas, oil, meat and farming products, dairy, sugar, and metals, etc. It can be applied in the securities market majorly in stocks and bonds. Besides securities, risks related to currencies, lending and borrowing interest rates, and weather can be hedged. On reading the weather, it might raise a doubt. This is because weather conditions such as heavy rainfall, hailstorms, or drought will severely impact businesses in agriculture, energy, travel, and tourism.
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Hedging is an investment status, which aims at decreasing the possible losses associated with an investment.
How does hedging work?
Let us understand this with an example.
We have invested in the shares of an automobile company. Let us say, we have purchased 100 shares for Rs 2000 totalling the investment to Rs 2,00 000 (100 X 2000). However, with the recent petrol price hike and people being cautious about discretionary spending, we can anticipate the stock price to fall. Therefore, to insulate from the loss we purchase the put option which is a derivative.
A put feature in options means the buyer buys the right to sell the stock at a certain price also called a strike price. So, under the put option, the buyer decides to sell the stocks at Rs 1900.
Now, in the normal case, if we do not hedge and suddenly the stock price drops to Rs 1800, we will get Rs 18,0000 (1800X100) by selling the stocks thereby incurring a loss of Rs 20000 ( 200000-180000).
Now, say we buy a put option. For every purchase of put option, we first choose the strike price and a premium is paid for choosing the same . Suppose, here we have chosen the strike price to be Rs 1900 and we pay a premium of Rs 50 per share, and for a total of 100 shares, the total premium to be paid is Rs 5000 (50X100). Now, at the time of selling when the price drops, we sell 100 shares priced at Rs 1900 getting Rs 190000. Since, we have hedged our investment the premium amount of Rs 5000 is deducted to become Rs 185000 (Rs 190000-5000). Due to hedging, the losses were minimised to Rs 15000 (Rs 200000-185000) than Rs 20000 when not hedged.
Advantages of hedging
Here are the advantages:
- Hedging enables investors to minimise losses to survive unfavourable market conditions.
- It can be used to earn profits consistently.
- It increases liquidity as it encourages investors to invest in different assets.
- It gives investor protection against commodity price variation, inflation, currency exchange rate changes, interest rate changes, etc. on successful hedging.
- Saves time as the long-term trader is not required to monitor/adjust his portfolio according to daily market volatility.
A word for the investors
Market risk and volatility are inevitable in the financial markets, amidst that the goal of investors should be to make profits. Hedging minimises risk losses since we are not in a position to manipulate or influence markets to protect our investment. We may not be getting 100 percent profits but with this, we can make small consistent profits and lessen the impact of huge losses.
