How to Hedge Your Stock Portfolio Using Derivatives in India

The stock market can give you a good return on investment, though it is still possible to lose if the market becomes unstable. Almost all the investors worldwide use derivatives to reduce exposure to these risks. Hedging can’ eliminate all risks, but it reduces potential losses while allowing you to keep your assets. Here, you will learn what hedging is, how derivatives work in India and some common strategies that keep your stock portfolio safe from sudden drops.

What is Hedging?

Hedging can be defined as getting an insurance plan to save the things you invest in from market fluctuations. Much like you protect your car from crashes, hedging assists in guarding your portfolio from a drop in the market. When done well, hedging can achieve the following results:

• reduce risk
• limit losses
• allow you to remain invested
• and not greatly impact your long-term returns.

Investors usually hedge by buying financial products that move opposite to their stocks, often using derivatives like futures and options in the Indian stock market.

What Are Derivatives?

A derivative is a tool that derives its worth from assets like stocks or stock market indices. Futures and Options are the main forms of derivatives in India which are used for hedging. Let’s take an example to understand what is Derivative in trading. Suppose the price of a stock will rise. But we do not buy the stock directly, instead we purchase a derivative that’s tied to that stock’s price. If the price of the stock goes up, your derivative agreement will also boost in value, potentially providing you a considerable return than the stock if you had bought that directly.

Why Use Derivatives for Hedging in India?

The Indian stock market is affected by many things, such as

• International economic trends and uncertainties.
• Domestic policy changes.
• Interest rate changes.
• Elections
• Currency shifts.

Due to these factors, Indian investors use derivatives to:

• Stop other companies from taking their profit.
• Reduce losses.
• Manage risks in an appropriate manner.
• Trade more calmly, as you are less concerned about shiftings in the market.

Key Benefits of Hedging with Derivatives

• Capital Protection: Protects your investments in case of major drops in the market.
• Mental Peace: Offers stability when the markets go through changes.
• Economical Risk Management: Index funds stand out with this strategy.
• Protects Investment Exposure: Gives investors a reason to stay patient, not rush to prematurely sell their investments.

Types of Derivatives Available for Hedging in India

1. Stock Futures: Stock futures involve agreeing to purchase or sell specific stocks at an agreed price on a given future date to avoid or manage risks from fluctuating prices of a given stock.
2. Stock Options: An option holder has the choice to buy or sell a stock for a specific price, as long as the option isn’t expired.

The two main sections are: 

Call option:The right to purchase

Put options: The chance to sell the stock.

One reason put options are widely used is that when stock prices go down, their value also rises.

3. Index Derivatives: Index futures and options are designed for the Nifty and Bank Nifty stock indices, allowing investors to hedge a portfolio that reflects a wide range of stocks.

Common Hedging Strategies in India

1. Put Strategy

Hedging like this is not only simple but also a favourite choice among many in India.

How the process functions:

• You already have the stock and purchase a put option for it.
• If the stock decreases in price, your put option increases in value and protects you from the loss you suffered.

Example:

• You are holding 100 shares of a company valued at ₹800.
• At ₹10 per share, you purchase a put option where the strike price is ₹780.
• If the stock is worth ₹750, the value of your put increases and reduces the loss you incurred.

Benefits:

• Keeps possible losses at a minimum
• Offers potential for more gains.
• It is easy to execute the idea.

Consideration:

You have to consider the cost of the option, even if prices don’t move in the market.

2. Covered Call Strategy

It is applied when you think a stock might not see significant growth.

Explaining how it functions:

• If you have a stock in your portfolio and decide to write a call option on that same stock.
• If the stock doesn’t exceed the amount you set as strike, you earn what you paid as premium.

Example:

• The shares you hold are worth ₹1,000.
• If you sell a call option for ₹1,050, you will receive a premium of ₹15.

Benefits:

Generates additional income through the premium received.

Premiums

Can help you keep some profit if the stock falls lightly

Consideration:

If the stock price exceeds the strike price, the profit is fixed.

3. Index Put Options can be used to protect your portfolio.

When your investments are tied to a stock market index, index put options are a simple form of hedging against risk.

How it works:

• Pay for a put option that follows the Nifty index.
• When the index drops, the value of your option will go up, offsetting the loss you face in your portfolio.

Example:

• The Nifty index mirrors your portfolio with a Rs 10 lakh investment.
• You decide to pay for a Nifty put option near the recent index rate.
• If the index goes down, the option gives you a payout.

Benefits:

• It is a low-cost investment suitable for everyone.
• Allows companies to avoid hedging their stocks.

4. Using Futures for Hedging

You can also use futures contracts to lock in the current prices of your investments.

How it functions:

• Trade a futures contract whose value is equal to what your stocks are worth.
• A drop in the stock price is balanced out by the gain made on the futures contract.

Example:

• You currently invested in 2 lakh rupees’ worth of stocks.
• You make a trade where the total value of the futures you sell is equal to what you buy.
• When prices fall, you earn money on the futures side.

Benefits:

• This is ideal for ensuring short-term safety.
• No money is needed at the start.

Consideration:

• A margin is needed for trading.
• Requires daily settlement transactions.
• There is no limit to how much can be lost if stock prices rise.

Recommended Read: Strategies & Benefits of Hedging in Futures Market

Tools That Help in Hedging

On almost all trading platforms, there are various methods you can use to hedge your portfolio.

• Analyzing option chains to determine which trade fits your strategy.
• Use payoff diagrams to show the possible results.
• Provides examples of hedging approaches so strategy builders can compare them.
• Calculators for computing your margin before futures trading.
• Live charts to track the prices of derivative instruments.

These tools make it easier to decide and provide a way to test your strategies ahead of executing them.

Things to Keep in Mind While Hedging

Contract Lot Designations: Accessible in lot sizes ranging from 25, 75 to 125 shares per contract, per stock.

F&O Trading: You can only trade them in the Futures & Options (F&O) segment of the stock market once the regulator permits.

Margin requirements: Futures contracts will require margin deposit every day, unlike share trading where it is not compulsory.

Expiration Dates: Contracts expire after a week or a month for index.

Taxation: Business tax rules apply to income from derivatives in India.

Conclusion

Traders and investors use hedging to reduce market risks and volatility. It helps minimise potential losses and increases the chances of achieving successful outcomes.

Recommended Read: How to Use Options for Hedging your Stock Portfolio