Wednesday 26 September 2007

Safe way to Invest in Stocks - Hedge it!

I got so many requests to write-up something on Hedging, protecting investments and F&O that i finally decided to jot down this article on those lines. Hedging is the process of offsetting the price risks inherent in any cash market position by taking an equal but opposite position, usually in the Futures/Options market. It is not as complex as it sounds. Let us take a live example to understand this better.

How to Hedge your investments

I will take a live example to demonstrate how an investment decision gone bad did not really affect the investor at the end of the day. For this demonstration i have chosen ITC trading on NSE. Take a look at the Chart alongside this commentary.

* On July 25th ITC broke long term downtrend with a Huge volume and Price Gain.
As you can see from the chart, the trendline was broken and it was a great time
to enter the stock.
* For all practical purposes, let us assume that we identified this stock at the End of the day on the 25th and decided to enter it on the 26th. Let us see how the trade went and how would have one hedged his/her position. Remember, the stock soared up almost 9% and which means it was reasonably risky to invest in it on any day after the 25th. Hence, not being 100% sure that the stock will go up, one would have played it the following way to reduce risk.
* On 26th, Buy 1000 Shares of ITC @ Rs.166. However, since we are not sure if the stock will continue to rally, we would Hedge this position to reduce risk. One should have Bought 23 165 Aug Put contracts that were trading at Rs.7.15. A total investment of Rs. 16,445. Now how the hell did we come up with the figure of 23 contracts? Since this investment was purely from a Swing Trading perspective, it was assumed with a 10% profit and 8% loss. The tight gap between profit and loss makes up overtime as swing trading is usually pretty short term, at the most a few days to a max of 1 month. 10% profit of 166000 investment is about 16600. Aug 165 call was being traded at 7.15 on this day and hence a max of 23 contracts could have been bought for this amount. Which means, we are risking our entire expected profits and buying Put options to safeguard our investment to the extent it can.
* So to sum up, on the 27th July we are having 1000 Shares of ITC at 166 and 23 Aug 165 Put contracts @ 7.15.
* Stock goes up for a few days and then it eventually decides to give the lower trendline a try. Remember, all along we had a Stop loss in place at 152(8% below 166, choosing the lowest Whole number). Though confident, we never sold our stocks or options.
* On the 21st of August, we really got nervous as our Stop loss hit and we were forced to sell our stock @ a loss of 14000 (166-152=14*1000). However, your options are now worth more. Options on 21st aug were being traded @ 12. Which means you would have been at a profit of Rs. 27600(23 contracts sell price) - 16445(23 contracts buy price) = Profit, Rs.11155. If you tally, your loss was NOT 14000, but only 2845. Because you hedged your position you were able to curtail your loss by over Rs.11100. Without such hedging approach you would have been at a loss of Rs.14,000.
* Of course, it is a different story that you should have probably waited and bought on the 21st of August because every breakout eventually tests the previous resistance which now becomes the support lines. If you did that, you would probably be sitting on a cool Rs.34000+ profit on your 160000 investment.

Hedging is a great tool to minimize risk and trade like a Pro. However for the indian markets it is limited to only a handful of stocks as not all stocks are optionable.