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HEDGING STRATEGIES
HEDGING STRATEGIESWHAT IS HEDGING?Hedging is a mechanism to reduce price risk
Derivatives are widely used for hedging
Its main purpose is to reduce the volatility of a portfolio, by reducing risk
Hedging does not maximizes the return it just reduces the variation in the returnHEDGING STRATEGIESOne of the popular strategies for hedging is : "If you are long in cash underlying - Short Future; and If short in cash underlying - Long Future
For e.g. If one has bought 100 shares of say Reliance Industries and want to Hedge against market movements, he has to short an appropriate amount of Index Futures. This will reduce his overall exposure to events affecting the whole market
WHERE HEDGING STRATEGIES ARE USEFULReducing the equity exposure of a Mutual Fund by selling Index Futures
Investing funds raised by new schemes in Index Futures so that market exposure is immediately taken
Partial liquidation of portfolio by selling the index future instead of the actual shares where the cost of transaction is higherHEDGING STRATEGIES FOR INVESTORSHedging Strategy #1 Dedicated Short Bias
Hedging Strategy #2 Fixed Income Arbitrage
Hedging Strategy #3 - Market Timing
Hedging Strategy #4 Aggressive Growth
Hedging Strategy #5: Opportunistic
To hedge short underlying position with optionsBuy call
Sell put
Buy call spread
Sell put spread
Buy semi-futures
To hedge short underlying position with optionsAnticipantsCharacteristics Short call Implied volatility downLimited profit - Unlimited loss - Limited protection - Cash credit - Risk profile at expiration equivalent to a short putLong putImplied volatility upUnlimited profit - Limited loss - Unlimited protection - Important cost - Risk profile at expiration equivalent to a long callShort semi-futures Implied volatility direction depends on the strikes
Buy put and sell call with a higher strike
Limited profit - Limited loss - Unlimited protection - Low cost - Risk profile at expiration equivalent to a long fence or a bull spreadTo hedge short underlying position with optionsshort call spread or bull spread Implied volatility direction depends on the strikes: Sell call and buy call with higher strike
Unlimited profit - Unlimited loss - Limited protection - Low cost - Risk profile at expiration equivalent to a long semi-futures
Long put spread or bear spread Implied volatility direction depends on the strikes: Sell put and buy put with higher strike
Unlimited profit - Unlimited loss - Limited protection - Low cost - Risk profile at expiration equivalent to a long semi-futures
To hedge long underlying position with optionsSell call
Buy put
Sell call spread
Buy put spread
Sell semi-futuresTo hedge long underlying position with optionsAnticipates Characteristics Short callImplied volatility downLimited profit - Unlimited loss - Limited protection - Cash credit - Risk profile at expiration equivalent to a short putLong putImplied volatility upUnlimited profit - Limited loss - Unlimited protection - Important cost - Risk profile at expiration equivalent to a long callShort semi-futures Implied volatility direction depends on the strikes: Buy put and sell call with a higher strike
Limited profit - Limited loss - Unlimited protection - Low cost - Risk profile at expiration equivalent to a long fence or a bull spreadTo hedge long underlying position with optionsshort call spread or bull spread Implied volatility direction depends on the strikes: Sell call and buy call with higher strike
Unlimited profit - Unlimited loss - Limited protection - Low cost - Risk profile at expiration equivalent to a long semi-futures
Long put spread or bear spread Implied volatility direction depends on the strikes: Sell put and buy put with higher strikeUnlimited profit - Unlimited loss - Limited protection - Low cost - Risk profile at expiration equivalent to a long semi-futures