Have you invested in any asset like stocks, commodities, etc. and now feeling afraid that the market might fall? If you are an investor, then you must have got this feeling many times. However, do you know that you can easily protect your portfolio by hedging it with Index futures?

So, let me tell you how to do it.

Index Futures.

Before we talk about hedging, let us quickly recap what Index Futures are.

Index futures are a type of derivative where the holder has the right to buy or sell an index at a certain time in the future. The purpose of these futures is to give traders more degree of control over the fluctuations in their investment portfolio. Traders who believe that markets are trending upwards, for example, can purchase long-term futures contracts instead of investing directly in stocks. Conversely, traders who believe markets are trending downwards can hold short-term futures contracts that allow them to sell their positions in the short term.

In India, we currently have Futures on 3 indices: Nify50, Nifty Bank (BankNifty) and Nifty Financial Services (FinNifty).

The appeal of these contracts is that they can be purchased and sold without the need for physical delivery. This makes them convenient and easy to trade. Futures contracts can also be used to hedge portfolios and protect them from losses when the markets fall.

What Is Meant By Hedging?

Many investors or entities that have an interest in the performance of the financial markets are often faced with the problem of how to protect their investments. One solution to this issue is hedging, which is a risk management technique that reduces the risk of adverse price movements.

The basic idea is to take a position on the other side of the market (i.e., buy and sell an asset) in order to offset any potential losses due to price fluctuations. The number of different strategies used for hedging is almost limitless, and there are many ways to describe them.

However, in this article, we will limit ourselves specifically to hedging with Index Futures. Let us understand how this works.

Step by step Process of Hedging With Index Futures

When you hold a portfolio, your risk is that the market will fall. Hence, you must hedge your portfolio to limit your exposure in such a scenario.

You can sell Index Futures (i.e., contracts on a specific index, such as the Nifty50) against the portfolio you are holding.

Here are the exact steps you will have to take:

Step 1: Build a portfolio

Step 2: Find an Index Future that is closely correlated to the portfolio

Step 3: Sell the number of lots of Index futures which is equivalent to (or near to) the value of the portfolio you have.

An example of portfolio hedging with Index Futures

You already know the steps. So let us understand this concept with an example now.

• Suppose you have a stock portfolio of Rs 10, 00, 000 and you are afraid that the market might fall.
• You decide to hedge it with Index futures of Nifty50
• The current value of Nifty50 is 17500 and the lot size is 50. Hence, the value of 1 lot of Nifty50 is (17500*50) = Rs 8, 75, 000
• Since you are holding (i.e., long) on the stock portfolio, you will have to take an opposite position to hedge it.
• Therefore, you sell 1 lot of Nifty50 Index futures worth Rs 8, 75,000
• The remaining Rs (10, 00, 000 – 8, 75, 000) = Rs 1, 25, 000 remains unhedged.

Now say the market falls by 10% and as a result, the Index Futures also falls by 10%. Now let us assume that the value of the portfolio also falls by 10%.

Hence,

• Loss from portfolio = (10% of Rs 10, 00, 000) = Rs 1, 00, 000.
• Profit from the short position in Index Futures = (10% of 8, 75, 000) = Rs 87, 500.

Hence the overall loss gets reduced to Rs (1,00,000 – 87,500) = Rs 12, 500. This was only possible because the portfolio was carefully hedged with Index Futures before the market crash.

I hope that by now you have understood the concept well.

“When the market falls, the value of your portfolio will fall, but the value of the index futures you have sold will increase. This rise will offset the fall in the value of the portfolio.”

Index futures are an excellent option for investors who are looking to hedge their portfolios. Be smart and hedge your investment portfolio with index futures when you expect the markets to crash.

If you want to know more ways in which you can protect your portfolio and get constant gains, then look at our innovative ‘Index Long Term Strategy’ that many investors like you have benefitted from.

Happy Investing!

This article is for education purpose only. Kindly consult with your financial advisor before doing any kind of investment.