Hedging with futures and options is an essential strategy for traders looking to minimise risk and reduce trading margins. Hedging is the practice of offsetting potential losses in investments or trades by taking an opposite position in a related asset, thus creating a safety net against adverse price movements.

Hedging with Futures and Options: Protect Your Portfolio or Account in Volatile Markets

Understanding how futures and options work is crucial for anyone who wants to understand hedging. This guide will walk you through the ins and outs of hedging, provide examples of futures and options strategies, and explain how to effectively manage your financial risks. This is, in a way, a risk management strategy that allows individuals to maintain a level of stability in their trades.

What is Hedging?

In simple words, hedging is a risk management strategy that involves taking an offsetting position in a related asset or financial instrument to minimise the potential loss from an adverse price movement. It’s like buying insurance for your investments. But it is used for different purposes or intents in different financial markets. Let’s explore hedging in some key areas:

Hedging in the Stock Market

The purpose is to protect against stock price declines. The methods used are:

1. Options: Buying put options (the right to sell a stock at a specific price) can provide downside protection.
2. Futures: Shorting stock index futures can offset potential losses in a stock portfolio.
3. Diversification: Investing in different sectors or asset classes can reduce overall portfolio risk.

Hedging in the Forex Market

The purpose is to protect against currency fluctuations. The methods used are:

1. Currency Futures: Trading currency futures can hedge against adverse exchange rate movements.
2. Options: Buying currency options provides flexibility in managing currency risk.
3. Diversification: Investing in multiple currencies can reduce exposure to any single currency.

Hedging in the Commodity Market

The purpose is to protect against price fluctuations in commodities like oil, gold, or agricultural products. The methods used are:

1. Futures: Trading commodity futures can help hedge against price changes.
2. Options: Buying commodity options offers flexibility in managing price risk.
3. Physical Hedging: Owning physical commodities (like gold) can provide a hedge against inflation.

Hedging in the Bond Market

The purpose is to protect against interest rate risk. The methods used are:

1. Interest Rate Swaps: Swapping fixed-rate interest payments for floating-rate payments can manage interest rate risk.
2. Bond Futures: Trading bond futures can hedge against bond price movements.
3. Duration Matching: Matching the duration of assets and liabilities can reduce interest rate risk.

Hedging in the Derivatives Market

The purpose is to manage the risk associated with underlying assets. The methods used are:

1. Options: Buying or selling options on stocks, indices, commodities, or currencies can hedge against price movements.
2. Futures: Trading futures contracts on various assets can offset price risk.
3. Swaps: Swapping interest rates, currencies, or commodities can manage different types of risk.

Understanding Futures Contracts

A legally binding agreement between two parties to purchase or sell an asset at a fixed price on a future date is known as a futures contract. It is a standardised contract that is exchanged in organised markets. Its essential elements are:

1. Underlying Asset: Deliverable assets, like stocks, currencies, indices, or commodities (gold, oil).
2. Contract Size: The agreed-upon, standard quantity of the underlying asset.
3. Delivery Date: The precise day on which the item is supposed to be delivered.
4. Price: The agreed-upon and established price for the underlying asset by exchange market forces.

How do futures contracts work?

1. Entering a Contract: Traders can take either a long or short position in a futures contract.
   • Long Position: Buying a futures contract with the expectation that the underlying asset’s price will increase.
   • Short Position: Selling a futures contract with the expectation that the underlying asset’s price will decrease.
2. Marking to Market: The process of settling profits or losses every day in accordance with changes in the price of futures contracts. This guarantees that traders keep enough margin in their accounts.
3. Delivery or Offset:
   • Delivery: At the contract’s expiration, the long position holder takes delivery of the underlying asset, while the short position holder delivers it.
   • Offset: Most futures contracts are not physically settled. Instead, traders close their positions by taking an opposite position before the delivery date.

Risks of Futures Contracts

1. Market Risk: A trader may experience losses if the price of the underlying asset moves against their position.
2. Counterparty Risk: The possibility of a default by the other party to the agreement.
3. Basis Risk: The difference in price between the futures contract and the spot price of the underlying asset may have an impact on gains or losses.

Types of Futures Contracts

1. Commodity Futures: Contracts on agricultural products (corn, wheat), metals (gold, silver), and energy (oil, natural gas).
2. Financial Futures: Contracts on stocks and indices.
3. Currency Futures: Contracts on foreign currencies.

Understanding the Options Contracts

A financial derivative known as an options contract gives its holder the right, but not the responsibility, to purchase or sell an underlying asset at a fixed price (referred to as the strike price) within a given window of time. Options provide flexibility in contrast to futures contracts, which impose obligations on the holder to purchase or sell the underlying asset.

Key Components of an Options Contract

1. Underlying Asset: The foundational asset of the option contract is this one. It could be another derivative, a stock, an index, a currency, or even a commodity.
2. Strike Price: The predetermined price at which the holder can buy or sell the underlying asset.
3. Expiration Date: The date when the option contract expires. After this date, the option is worthless if not exercised.
4. Premium: The sum that the option buyer must pay to acquire the contract.

Types of Options: The Calls and the Puts

There are two types of options contracts: call options and put options.

Call Options

From the standpoint of the buyer, the buyer of a call option is entitled to purchase the underlying asset at the strike price. When the asset’s market price is greater than the strike price, this right is valuable. Under this scenario, the buyer can profitably exercise the option and buy the asset for less than the going rate.

• Profit Potential: Unlimited
• Loss Potential: Limited to the premium paid for the option

From the standpoint of the seller, in the event that the option is exercised, the call option seller (also known as the option writer) is obligated to sell the underlying asset at the strike price. They take on this responsibility in exchange for an upfront premium.

• Profit Potential: Limited to the premium received
• Loss Potential: Unlimited if the asset price rises significantly.

Put Options

A buyer of a put option is entitled to sell the underlying asset at the strike price. When the asset’s market price is less than the strike price, this right is valuable. In this case, the buyer has the option to exercise it, sell the asset for more than the going rate, and profit.

• Profit Potential: Limited to the difference between the strike price and the asset price
• Loss Potential: Limited to the premium paid for the option

A put option seller, also known as an option writer, is obligated to purchase the underlying asset at the strike price. When the asset’s market price is higher than the strike price, this right is valuable. They take on this responsibility in exchange for an upfront premium.

• Profit Potential: Limited to the premium received
• Loss Potential: Limited to the difference between the strike price and the asset price.

In order to understand options contracts better, you may refer to this article on option trading, which even goes into detail about different buying and selling strategies.

Hedging with Futures and Options

In order to reduce the risk of unfavourable price movements, traders and investors in the stock market frequently use futures and options hedging. When combined, these two derivative instruments can offer a more customised and adaptable approach to hedging than when used separately.

As an experienced trader, this strategy allows me to make the most of the available margin I have for my trades. Let me explain why I do it and how I do it.

Issues with Trading Uncovered Futures and Options

1. If you’re an option buyer, your biggest enemy is theta decay. You can’t hold positions for longer periods of time.
2. The best results in option buying are given to scalpers, but profitability in scalping is really hard to achieve.
3. Due to their vulnerability to intraday volatility and inability to execute swing trades, which are considerably simpler to book profits from than scalping, the majority of option buyers are stopped out quickly.
4. High margin requirements are your worst enemy if you are an option writer or seller. Even though the margin requirements for selling options are the same as those for futures, you never get linear returns like futures do due to variable delta, even though theta decay becomes your friend.
5. You’ve got, theoretically, limited profits and unlimited losses if you’re an option seller.
6. If you’re trading naked futures, everything is perfect except the fact that you’ve got to pay a very high margin for trading them.

Hedging Futures with Options Solves Everything

So when we use options contracts to hedge our futures positions, we can limit our potential losses while still benefiting from the leverage that futures offer. This strategy allows you to manage risk more effectively and potentially increase your overall profitability in the long run. Let us see through Sensibull’s Strategy Builder tool in these pictures how hedging solves the problems mentioned above:

This is the margin one would need to put forward in order to trade a single contract of NIFTY 50 futures as of August 2024.

Then this is the amount of margin required to trade the same quantity of the NIFTY 50 futures contract if we hedge it with an options contract in August 2024.

Take note that you’ll earn less profit as compared to a naked futures contract of the same quantity.

Lastly, this is the amount of hedged futures contracts you can trade all together with the same amount of margin that you’ll need for a single naked futures contract of the NIFTY 50 futures in August 2024.

You can create a free Zerodha’s Kite account in order to access Sensibull’s vast toolkit, which includes the strategy builder that we used in this example.

Important Considerations

1. Contract Specifications: The expiration date and strike price of an options contract should be carefully chosen based on the investor’s risk tolerance and market outlook.
2. Transaction Costs: Keep in mind the costs of hedging futures contracts with options contracts, as these can have an impact on the trade’s overall performance since the costs are slightly higher.
3. Market Conditions: The effectiveness of a hedging strategy can vary depending on market conditions. It’s essential to monitor the market closely and adjust the hedge as needed. It’s advisable to virtual trade through Sensibull first to understand how these operate in different market conditions.

Final Word

Hedging with futures and options is a valuable tool for investors and traders looking to manage risk and protect their portfolios or trades. By understanding how futures and options work and by implementing effective hedging strategies, one can help safeguard their investments and trades from market volatility. However, it’s important to remember that hedging is not a foolproof way to eliminate risk. There are also some limitations to consider, such as the costs associated with using futures and options contracts. Overall, hedging can be a powerful addition to your investment toolkit, but it’s important to use it wisely.

FAQs

Why is hedging important for protecting assets in volatile markets?

Hedging is like protection for your investments. It helps protect you from losing money when prices of things like stocks, commodities, or currencies change unexpectedly. Investors can use futures and options to set prices or reduce potential losses, helping them have more consistent results even when the market is unstable.

What’s the key difference between futures and options for hedging strategies?

Futures contracts require you to buy or sell an asset at a set price on a future date, which helps secure prices. Options let you buy or sell an asset without obligation, providing a way to protect against losses and take part in possible gains. Futures carry more risk because of the obligation, while options require a premium for flexibility.

What is the cost of hedging with futures and options?

Hedging costs differ: futures usually need margin deposits and might have rollover fees if extended. Options require upfront payments to secure the contract. Extra costs are brokerage fees and possible missed opportunities if markets improve, but your hedge restricts profits.

Can small investors use futures or options for hedging, or is it just for institutions?

Yes, small investors can hedge. Many brokers provide mini futures or options contracts that need less capital. It’s important to know the risks, costs, and strategies. Stop-loss orders and protective puts make hedging easier for individuals.

What mistakes should investors avoid when hedging with derivatives?

Common mistakes are over-hedging, not updating strategies with market changes, and mispricing contracts. Relying only on hedging without diversifying the portfolio is another mistake. Align your hedge with your risk and goals.