Hedging Technique ?

Hedging is used to reduce the potential loss on any trade. If you have bought a stock, you can hedge this position by selling a futures contract on it, or buying a put on that stock. If the stock declines, you lose on your stock position, but gain on your futures position, or put position, thus reducing your loss. If the stock moves up however, your gain will be less than that of an unhedged position.
What you have to decide is how much of your equity position you wish to hedge and sell those many futures, or buy those many puts on it.
Futures markets in the west have traditionally been used for hedging purposes. Where the speculators provide the liquidity to physical traders to offset their risks. For eg a wheat farmer in the month of June may estimate that his farm would yield about say 50000 bushels of wheat (wheat is traded in bushels on CBT) when he harvests the wheat say in the month of September and if he has estimated that his all inclusive production cost are for eg. US$ 4.00. Iff the wheat trading for September delivery is currently (ie. in June) is trading at US$ 4.50 - clearly a profitable situation exists for the farmer.

Then he can hedge his entire production by selling equivalent September contracts in June for September delivery even before harvesting and offset his risk and earning a 50c profit on his production.

The purpose of hedging is to offset risks. Speculators will take on this risk and provide liquidity to producers - on the basis that the price of wheat which is currently (in June)trading at US$ 4.50 may go higher and they may make profit on the risk that they have just from the farmer.

Hedging (means evade) is actually a very wide subject. For a lay-man hedging is insurance. Hedging can be done using the derivative market. There are a veriety of oppurtinity to hedge ur risks in the western market but the concept of derivatives is a very new one in the indian market. There are only 2 ways here - the Futures & options. The F&O are literally contracts of a future date & price on a index, stock or commodity. There are many risk applicabe to a stock say the risk of performance, management etc which we can categorise as a company centered risk and the risk of market performance like sensex crashing to 6500 the price of a certain scrips can go down on the market sentiment. and other risks . So to evade the risks or hedge our risk we can make a contract with a person with a counter view ( mind it : for every view in the universe there is always a counterview) to buy or sell the specific stock or index at a certain price in a certain time in the future.

Hope this helps someone, if anybody wants to know more about F&O Please ask.


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