To hedge or not to hedge

Hedging is advisable, provided you have adequate time and the skills, and are willing to incur the extra costs

“Think long-term,” “ignore short-term noise,” “don’t panic and just stay put” — these are some of the instructions that have been drummed in to you from the time when you were a greenhorn in the world of equity investing. But when faced with a turbulent phase, it is quite difficult to go around with a beatific smile, believing that stock prices will right themselves soon.

Most investors, when faced with such conditions tend to react in either of these ways — One, do nothing in the hope that there will be a bounce-back soon that will take stock prices back to their previous highs.

Two, sell part of their holding, especially stocks that appear overvalued or those that have recorded sharp appreciation. Three, hedge with the help of equity futures or options to neutralize the price erosion, if it happens.

The first option is for you if you are long-term, risk-averse investor and if your equity holding mainly consists of large-cap blue-chip stocks, since blue-chips almost always regain their mojo, given time.

But if you hold a mix of large, mid and small-cap stocks, getting into a zen-like state will punch large gaping holes in your portfolio.

You can try to book profits on some of the riskier stocks and try buying them back later, but timing the market is not easy.

A better way to counter the loss that can arise in the event of a market fall is by hedging the portfolio. This is akin to buying an insurance, where you pay a certain sum to protect yourself against future loss. If you expect the prices of stocks in your portfolio to fall, you need to buy assets or instruments that have an inverse relationship with stocks; those that will move higher when your stocks go down. The profit you make from your hedge can thus reduce the pain to some extent.

The need to hedge

A structural bull-market, akin to the current one, that lasts many decades, tends to instil a feeling of complacency among investors. The talking-heads on the business news channels keep telling you to believe in the long-term India growth story, that this is just another blip. Their advice is easy to believe, given the market behaviour over the last 10 years. New investors who have entered the market after 2008 have not seen a serious market correction yet.

But as discussed in the box, “Why you need to take cover” declines of more than 40 per cent from the peak have occurred six times in the Sensex since 1979. The steep rally over the last two years, without real fundamental backing, makes market especially vulnerable at this juncture.

When corrections are shallow — decline of less than 20 per cent from peak — chances of stock prices regaining their former peaks are higher. But in the deeper declines (more than 40 per cent correction), some stocks get pummelled to such an extent that they do not regain their previous levels. Assuming that all stocks will revert to their peaks is, thus, not right.

For instance, DLF was trading above ₹1,200 in January 2008, but fell to ₹124 by February 2009 and has not crossed ₹300 since 2011. It’s the same story with GMR Infrastructure which has not been able to regain its December 2007 peak of ₹131 and currently trades at ₹17.

However, while hedging is advisable if you hold a sizeable portfolio, it is not suitable for everyone. One, it involves skills in trading in derivative market, which is not everyone’s cup of tea. Two, only those with adequate time on their hands should consider hedging with futures and options. Three, there is cost involved in buying a hedge. If you do not want to incur the extra cost, then you can stay away from hedging.

Those who do not want to hedge with derivatives should pay greater attention to portfolio diversification, that can reduce the risk to some extent. Try to spread your investible surplus across various assets such as equity, debt, real estate and some gold so that erosion is limited to a smaller part of your portfolio. Your equity portfolio can also be invested in stocks from various sectors so that weakness in one sector does not drag down the entire portfolio.

If you are game to try your hand at hedging with the help of futures and options, read on.

Stock or index derivative?

A simple way to hedge the stocks you hold will be through stock futures and options. Say, you hold 1,000 shares of Reliance Industries valued at ₹9,22,000. Since RIL is the market bellwether, it is likely to lead the other stocks lower in the event of a severe decline. Instead of selling your entire holding, you could sell one RIL future contract, valued at ₹9,22,000. If the price moves lower by ₹50, the value of your holding will reduce to ₹8,72,000. But the short position in the future will give you profit of ₹50,000, thus compensating for the loss.

The problem, however, is that derivatives are available on only 207 stocks whereas over 2,000 stocks are actively traded on Indian bourses. There are futures and options available on few indices such as Nifty bank, Nifty CPSE, Nifty IT, Nifty PSE and Nifty infrastructure. If you have significant holding in stocks of either of these sectors, you could sell futures or buy puts of the relevant sector index.

A more popular method to take cover for your portfolio is through the use of Nifty futures and options, the entire portfolio can be hedged through just one instrument using this. But before you do that, calculate the beta of your portfolio.

How much should be hedged?

Understanding the concept of beta also helps us understand the proportion of portfolio that has to be hedged. A stock’s beta vis-à-vis the index represents the sensitivity of the stock price to the index movement. If a stock has a beta of 0.7, it means that if the index moves 1 per cent, the stock price will move 0.70 per cent.

 

A stock’s beta can be calculated in excel by first downloading the stock prices and index value (say, Nifty) for one year. Next, calculate the daily price changes and then get the beta for the stock versus the index using the SLOPE function in Excel.

Since different stocks in your portfolio will have different betas, you have to arrive at the portfolio’s beta by assigning weights to each stock based on its proportion in the total portfolio value.

Suppose the value of your portfolio is ₹50,00,000 and the portfolio beta is 0.80, it would be ideal to hedge for ₹40,00,000 (₹50 lakh multiplied by 0.80).

Since the value of each Nifty contract is currently around ₹7.5 lakh, you can hedge by buying five contracts of Nifty future or option (₹40 lakh/7.5 lakh = 5.3). Since it is not always possible to hedge for the exact value, it is almost impossible to buy a perfect hedge.

Futures versus options

Once you have zeroed-in on the value you want to hedge, you will have to decide whether you want to use futures or options to hedge. It is more straight-forward to hedge with the help of futures, but the initial outlay is higher.

You have to pay a margin varying between 8-12 per cent of the contract value at the time of initiating the position. Some brokerages could waive margins, using stocks held by you as collateral. Then depending on the price movement, mark-to-market profit or loss will be added or deducted from your trading account. So there could be additional outgo in some situations. Also, the loss that you may have to bear is unlimited in future contracts.

Options appear complicated due to multiple contracts (at different strike prices) for each month, but the risk is limited in these contracts since the buyer of the option has the right, but not the obligation, to exercise the contract. Your liability will be limited to the premium paid.

While charges vary across brokerages, it is typically around 0.03 per cent of the contract value for futures and could be ₹60-80 per lot for option contracts. Some brokerages also charge a percentage of the option premium as brokerage.

Since the strategies to hedge are not intended to result in profits, there is unlikely to be capital gains on these transactions. If there is a gain, it has to be accounted as non-speculative business income in your income tax return.

Our take

Using futures to hedge your portfolio is simpler, but the loss you can incur, if your reading of the market direction is faulty, can be quite high.

It would be better to use put options to shield your shares. Initiating a ‘married put’, where put options are purchased at-the-money (closest to the market value of the Nifty) will work as well as a future contract. While these contracts could be expensive, they are more likely to provide a good hedge.

Your position turns profitable as soon as the Nifty declines below the strike price adjusted for the premium and other charges paid. For instance, if you buy puts at 10,500 strike price at a premium and other costs of ₹100, the position will turn profitable as soon as the Nifty value declines below 10,400 (10,500 – 100).

If you are a savvy investor, you could sell Nifty call at a slightly higher level, so that the premium earned from selling the call can reduce your outgo in buying puts. But this strategy can reduce your profits if the market reverses higher.

Buying long-dated put contracts for hedging, such as Nifty put options expiring in December 2019 or December 2020 can also be considered if your broker facilitates this.

Why you need to take cover

The Indian stock market has been in a structural bull market since 2003, with the Sensex gaining at a compounded average growth rate of 17 per cent over the last 15 years. Except for the steep correction witnessed in 2008 that dragged the Sensex 62 per cent lower, there have not been any other major declines.

 

The rally has been especially unrelenting since August 2013, with Sensex almost doubling in the last five years. As the adjacent table shows, barring the 25 per cent correction between March 2015 and February 2016, it has mostly been an upward ride for Indian investors in this period.

It is, therefore, not surprising that most investors firmly believe that a deep stock market decline is highly unlikely. They could be proved wrong, for deep market correction of over 40 per cent from the peak, have occurred quite frequently in the past. If we consider the Sensex movement since 1979, there have been six instances when the Sensex lost between 40 to 60 per cent from its peak. The declines have lasted from 5 to 21 months.

What’s of concern is that the rally since 2013 is driven mainly by demand from domestic funds and does not have sound fundamental mooring. Besides, weak earnings and elevated valuations in many pockets of the market, rising crude oil prices, rupee threatening to retreat to an all-time low against the dollar and ceaseless FPI outflows place Indian stocks on pretty shaky ground. With investors chasing stocks in sectors with decent earnings growth, the valuations of these stocks have become pretty uncomfortable.

Most market veterans would agree that, roughly speaking, a major market peak tends to occur once in every eight to 10 years. This belief has its roots in the stock market cycles discovered by Samuel T Benner, a wheat farmer and a renowned statistician, who used pig iron prices to plot multi-year market cycles in 1875.

According to him, market peaks were formed at intervals of eight, nine and 10 years, while minor and major market lows were formed at intervals of 16, 18 and 20 years.

A J Frost applied this cycle to Dow Jones Industrial Average to predict the next 10 years quite successfully in 1965. The projections for the Dow are put out in the book, Elliott Wave Principle. But these projections stop at 1987.

If we try to project Benner’s cycles further, we get some surprising results.

This cycle identified the peak in 2000 and 2010 and projects the next significant peak for markets in 2018. Similarly, the major trough in 2003 was rightly identified by this cycle and the next trough is projected in 2021.

While this can only be used as a guideline and the dates can be off by a year or so, it always pays to play cautious and hedge.

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