Hedging in cash and future

nillohit · #1 13th October 2005, 05:05 PM

Hi,
I am seriously thinking to start hedging as investment strategy. Mainly in spot and futures. Any information on procedures, loopholes, advices will be highly appreciated from any and all members. Senior members are requested to through some light from their experience too.
Regards,
Nillohit

nautilus · #2 13th October 2005, 09:46 PM

Quote:

Originally Posted by nillohit

Hi,
I am seriously thinking to start hedging as investment strategy. Mainly in spot and futures. Any information on procedures, loopholes, advices will be highly appreciated from any and all members. Senior members are requested to through some light from their experience too.
Regards,
Nillohit

Nillohit Hi:

Your first sentence is rather perplexing where you state "I am seriously thinking to start hedging as investment strategy".

Hedging as far as I am aware (I stand corrected) is utilised for the purpose of protecting your physical investments, stocks and shares, produce from declining in value. It can be used in many ways by different participants but its main purpose is protection from adverse price movements - and the instruments mainly used for hedging can be futures, forwards or options - on long or short side - depending on what one is trying to hedge.

For eg. if you hold 10000 Infosys shares which you have bought at say Rs 500 and they are currently trading at Rs 1000, and you are worried that the market will decline very sharply over a short period of time - then to hedge you would sell futures in Infosys at around Rs 1000. In case the market declines to Rs 600 as you had thought then you would have locked your profits in Infosy at around Rs 1000 - This strategy would then hedge your physical position in Infosys shares - and protect your profits.

Trading a hedge:

Instead if what you mean is:

That once the decline in Infosys shares is over and it starts rising again from Rs 600 and say you decide to buy back your futures position at Rs 650 - then you would have made a profit of Rs 350 =(1000-650) per Infosys share and you would still be Long Infosys shares at Rs 500 your original purchase price - then this would be called trading a hedge where you initiate and close out futures legs as and when you think fit - but by classic definition this not a true hedge and involves a fair amount of speculation.

Is this what you mean in your first sentence or have I misunderstood you? Also what are you planning to trade in the spot market?

I may be able to throw some light on the subject if I know some further details of your plan.

Regards
Nautilus

ivanboesky · #3 14th October 2005, 12:59 PM

I think what nillohit means is that he does not want to take on any market exposure, and instead arbitrage between the cash and futures market to make market neutral returns. Is that what you mean nillohit?
If that is the case then, its pretty straighforward. Set up a screen to monitor the cost of carry, and when you get your desired differential, sell the futures and buy the spot. You should have a reasonable estimate of the transaction costs to make the arbitrage truly profitable.
Also watch out for stocks that are *** dividend, etc. where some adjustments will have to be made, to estimate the cost of carry.

ivanboesky · #4 14th October 2005, 01:00 PM

Errr... the word "***" from ***-dividend has been blotted out!!

ivanboesky · #5 14th October 2005, 01:00 PM

Okay okay... i mean come-dividend (pardon the spelling)... the opposite of ex-dividend....

usha · #6 14th October 2005, 09:23 PM

Quote:

Originally Posted by ivanboesky

I think what nillohit means is that he does not want to take on any market exposure, and instead arbitrage between the cash and futures market to make market neutral returns. Is that what you mean nillohit?
If that is the case then, its pretty straighforward. Set up a screen to monitor the cost of carry, and when you get your desired differential, sell the futures and buy the spot. You should have a reasonable estimate of the transaction costs to make the arbitrage truly profitable.
Also watch out for stocks that are *** dividend, etc. where some adjustments will have to be made, to estimate the cost of carry.

HI IVANBOESKY,

You mentioned "arbitrage" I was asking many about it between BSE TO NSE, Between cash to futures but it was a new term to them. So I thought may be it is not possible in our country. Can you please elaborate on this topic? I have heard that it requires quite a big some of money to arbitrage bt. cash and futures how is it? what is transaction cost?
Bye
usha

ivanboesky · #7 15th October 2005, 11:55 AM

Arbitrage between BSE and NSE is possible, and is done by a few, but I dont know how profitable it is, or could be.
More common is arbitrage between the cash and futures. When the cost of carry exceeds your borrowing cost, you could buy in the cash market and sell in the futures market, thus earning the spread, as convergence between the cash and futures would occur by expiry. As for the funds, you will need to put up the entire amount that you have bought in the cash market, and a margin amount for the short futures position. So, if you buy 1 crore in the cash market, you will need to put up around 10 lakhs for the short futures margin.
Check up with your broker for the transaction costs.

nillohit · #8 16th October 2005, 12:15 PM

Hi Nautilus,
First and foremost, thanks a lot for showing your interest in replying my quory. You are very correct that I was a bit ambigous. Actually what i meant was correctly assessed by Ivanboesky - Arbitrage between cash and futures market to make small but riskless profit.
This hopefully cleares the confusion that has been inadvertently created. I am eagerly waiting for your views and comments.
Regards.

nillohit · #9 16th October 2005, 06:07 PM

Quote:

Originally Posted by ivanboesky

I think what nillohit means is that he does not want to take on any market exposure, and instead arbitrage between the cash and futures market to make market neutral returns. Is that what you mean nillohit?
If that is the case then, its pretty straighforward. Set up a screen to monitor the cost of carry, and when you get your desired differential, sell the futures and buy the spot. You should have a reasonable estimate of the transaction costs to make the arbitrage truly profitable.
Also watch out for stocks that are *** dividend, etc. where some adjustments will have to be made, to estimate the cost of carry.

Hi Ivanboesky
You are right on the dot in assessing my problem- what i really mean is arbitrage between cash and futures market. What is your observation about it . Is it feasible as a strategy? Moreover during this bear phase is it equally effective? I have taken up Sharekhan trading terminal and find it pretty useful. I get basis of most of the stocks but what is a desired/standard difference. Is there any yardstick for that? And is there any other indicator that i should consider apart from basis?
Regards.
Nillohit.

ivanboesky · #10 17th October 2005, 08:56 AM

Yes, arbitrage is definitely useful to make some risk free money... the only problem being that these opportunities disappear during the market downturns. In downturns, the futures trade below the cash market price, due to hedging/ portfolio insurance and speculation. This makes this strategy unviable. But during a period of unbridled rampant market rise, this strategy can make you some good money.
"Basis" by itself does not mean anything for 2 reasons... one, it does not reflect the price that the stock is trading at, and two, it does not acccount for the number of days between the day you are entering the transaction and the settlement of the futures.
You will have to compute the annualized cost of carry and base your decisions mainly on that parameter.