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Hedging

In finance, a hedge is an investment that is taken out specifically to reduce or cancel out the risk in another investment. Usually they come in 2 flavors Options and Futures.

Take a farmer (the earliest form of hedging): you expect to grow wheat and expect the price to be 800 per quintal with a cost of 600/- for you. Now if the price of wheat after 6 months is 700/- , your profit reduces by half, without any fault of yours. Similarly increase of price to 900 will increase your profit by a third. So:

1) So you take the price fluctuation as an act of god and live with it (or maybe even commit suicide).
2) You fix the price with the grain merchant by having a futures contract with him. So irrespective of the market prices at the time of harvest you will be paid 790/- per quintal. You lose 10/- but it removes the uncertainty from the mind of the farmer. On the other hand the merchant earns an extra 10/- plus he is assured of the grain even if the prices go sky high. So for a small fee, all the uncertainty is transferred to a second party.
3) The farmer might not want to lose on the windfall he might make if the price rises. So he instead of the derivative, he buys an insurance policy (the option contract). This contract gives the farmer a legal option to sell at 800. For the merchant to bite this bullet he pays him a sum upfront say 15/- (which is non returnable). So if the price falls, he sell it to the merchant at 800/- and is shielded from any losses. However if the price of the wheat rises above 815/- he actually makes a profit by selling it to the open market.

Point 2 is an example of futures, while point 3 is an example of options. Together these 2 constitute the derivatives market which is used for hedging your stocks.

22 replies on “Hedging”

According to Warren Buffett “Derivatives are financial weapons of mass destruction”

//Example 3 is not clear. Why should the merchant go for the option?//
ram all fair trades happen only when both the party feel that they r benefiting. The merchant feels that the price would go down and 15/- is a good enough premium for the risk he is taking.

//How does he benefit: the initial down-payment?//
exactly.

//How does this translate into a modern F&O market?//
If you understood this post, then you are almost there.

The only difference from the modern market is that the stock exchange would open ask the parties to pay some margin amount (in cash/stocks) for surety (so that none of the 2 parties default in case of futures and the merchant in case of options can default).
Also based on the daily fluctuations in the price of wheat/stocks the margin requirements would go up/down.
and also it will allow both the merchant and the farmer to sell this contract to a 3rd party any time. So one does not have to wait till harvest to see the returns.

I still cannot understand how option 3 is a benefit for the merchant.

If the price is below 800, farmer sells for 800 to the merchant, and expenditure for the merchant would be 815, where as the actual price is less.

If the price is 800, farmer sells to the merchant, and it costs 815 for the merchant.

If the price is above 800, farmer sells in the open market, and merchant loses 15.

In which case, is it profitable to the merchant?

@satish…
i agree options r a bit tricky… but u got it all wrong… the 15/- premium is paid by the farmer to the merchant (and not the reverse)
the market expects the price to be at 800/- (at the time of harvest) and the premium paid was 15/-
If the price is below 800, farmer sells for 800 to the merchant, and expenditure for the merchant would be 800 – 15/-, so the merchant will suffer a loss.
However if the price is above 800/-, the farmer will choose not to exercise the options.. in that case the merchant pockets 15/-
and the reason why this transaction happened was because the merchant thought the prices will go down.. and hence he will make 15/-
future market is a zero sum game. farmer’s loss is merchant’s gain and reverse…..
but think it as an insurance policy which the farmer has bought.

Ankur, You’ve made a fundamental error in your explanation: Options are a type of derivatives. So, options are also an example of derivatives, in the same away that futures is an example of derivatives.

Options are of 2 types- Call (The buyer has the RIGHT, but not the obligation to BUY the underlying goods in the future) and Put (the buyer has the RIGHT, but not the obligation to SELL the underlying goods in the future.

Futures, on the other hand, OBLIGATES the BUYER to either BUY/SELL the underlying goods in the future.

Please do not mislead your readers like this.

Forgot to add- Both Options and Futures can be used for Hedging purposes. Whether a person will go for Options or Futures, depends upon his hedging risk/return profile and other envt. circumstances. It might be poss. that the underlying goods don’t have a futures contract available or an options contract available.

Just saw that in your explanation for Example 3 to RDoc, you’ve confused Futures with Options. The Margin Requirement doesn’t apply to Options (Where all that you pay is the upfront premium) and only applies to Futures

wow nice arguements and a unique style of explaining
this part is darn easy
ruhi u pointed out the nitty gritty very nicely 🙂

rdoc sharekhan has a nice pdf expaining stuff on their site

will u care to differentiate between Indian European and American fno
plus how is it done realtime???

i think buffet was referring to advanced derivatives that tend to be rather creative stuff that got companies like Enron to their doom…

overall nice post

@Prax

Thanks. Yes, the advanced derivatives can be consructed out of different combinations of otpions. Like Bull Spread, Bear Spread, Butterfly Spread…etc. But to understand all that, you need to first know the nitty gritty of the fundamental call and put options and the various graphs. 🙂

@ruhi…
//You’ve made a fundamental error in your explanation//
this is the part where my lack of financial degree kills me…. *thanks* for pointing out… i made the correction.
In my quest to avoid PUT/CALL, margin , spreads and all the technical terms i goofed up a bit.
PS: there is another post coming today which will try to introduce some of those terms. Please edit that also for me.

//The Margin Requirement doesn’t apply to Options//
r u sure, i know to buy a margin you only pay the initial option premium. but the person who writes/sells the options has to pay some margin (calculated by the exchange)

@prax…

//overall nice post//
thanks.. you will still have to roll ur sleeves and go through the graphs and charts before investing.

//will u care to differentiate between Indian European and American fno//
The ones traded at NSE are american by default. the basic difference is that.
In European options, the farmer can exercise the option *only* on the maturity date.
In American option, the farmer can exercise it *any time* till the maturity date.

plus how is it done realtime???//
i am not sure what you mean by that… basically the price of the underlying security will fluctuate and the premium/price and the margin will also fluctuate with it…

//i think buffet was referring to advanced derivatives//
Derivatives is a zero sum game…. it is not like typical stock market where the industry creates wealth and shares it with its stake holders….
hence they r evil and can go awfully wrong.

//r u sure, i know to buy a margin you only pay the initial option premium. but the person who writes/sells the options has to pay some margin (calculated by the exchange)

Yes, but that needs to be pointed out properly, right? It would help your readers, if you have used have a simple equation like this-

S-X=C, where S= stock price, X= strike price, and C= call option premium. So, if S>X, the call options buyer makes money and the call options seller loses money.

X-S=P (X= strike price, S= stock price, and P= put option premium). So, if the strike price exceeds the stock price, the put option buyer makes money and will exercise the option and the put option seller will lose money.

Since options give the buyers only the RIGHT to buy/sell, the call/put options will only be exercised if they buyer has a profit, right? Nobody is going to exercise the deal if it results in a loss.

//Derivatives is a zero sum game…
Yes, but the profit and loss that a party can make is not *Exactly* the same. The upside/downside potential can be radically different, depending upon the type of derivative that you’re using.

Btw, there is another instrument that can be used to for Hedging- Swaps and Swaptions. Most of the major banks and other financial institutions enter into swaps worth billions of dollars every year. So, I would change that statement “Usually they come in 2 flavors Options and Futures.” and “Together these 2 constitute the derivatives market which is used for hedging your stocks.”

//if you have used have a simple equation like this-//
i tried to keep away from equations and maths… and stick to philosophy/theory behind fno. but i agree i over simplified the issue.

//Nobody is going to exercise the deal if it results in a loss.//
yes.

//The upside/downside potential can be radically different, depending upon the type of derivative that you’re using.//
ya but unlike shares where the wealth is created, in derivatives it just flows from one pocket to another.

//Btw, there is another instrument that can be used to for Hedging- Swaps and Swaptions. //
i have heard a lot of about it, but never had a chance to understand it… tell me more.

yups a lot of my info comes from that… investopedia has explained each and every term very nicely.

@ruhi…
indian options market has very low volume (esp if you are trading in nifty) and most contracts are the near month ones….. so that gives a lot of chance to dictate the prices and make pot full of money. have you ever thought about using your mba here?

Ankur,

you’ll find lots of material on swaps even in that book i sent you. your comment gave me an idea- probably i’ll do a post on swaps and let you know. 🙂 that might make it easier for you to understand the basics.

Yes, I do know that the Options Market has very low volume. But if it’s that way, then I’m sure you pay a very high premium, right? Low volume means higher risk, which implies a higher premium. So you will need a greater swing in the price to make money. My parents used to trade a lot in the derivatives, but then they stopped after suffering some losses. I feel that it’s easier to make money if you have different time spans for the options…that way you can decide what you think the movement will be and accordingly buy a suitable option. Esp. if you’re hedging , then the timing of the expiration/exercise of the option becomes very imp.

//have you ever thought about using your mba here?

No…haven’t thought about that. 🙂 Maybe 5-6 years down the line if I move back to India. More than the MBA, it’s really the CFA Designation that’s making me into a better analyst. It’s a pity that they’re not allowing Indians to register for it anymore, because of the recent court case.

//you’ll find lots of material on swaps even in that book i sent you. //
yups.. and i wrote another post yesterday describing some more basic tricks (using actual data)

// probably i’ll do a post on swaps and let you know. :)//
u could probably write it on ENagar itself… 🙂

// that might make it easier for you to understand the basics.//
yups, you know i am an unending thirst for knowledge.

//Low volume means higher risk, which implies a higher premium. //
low volume means that the buyer (you and I) can dictate the terms. there would be lots of guys who hold options contract at prices 20-30% off the current prices and want to square off their deal (booking profits/losses). All that is required is a guy who can spot them and offer to buy it at your own terms.
Thats what I do and it has been very successful. (I made about 1.4L last friday itself on a single contract)

//So you will need a greater swing in the price to make money. //
usually you make double or nothing within a week.

//My parents used to trade a lot in the derivatives, but then they stopped after suffering some losses. //
same here.. 6 months ago I used to trade a lot in derivatives.. but these days i stick to options. (but i trade only when i am dead sure about the trend)

//I feel that it’s easier to make money if you have different time spans for the options…//
that would be a problem. Most contracts at this moment are ending at 31st Jan. 28h Feb contracts have too low a volume and too high a price. so basically you have to have a 1-3 week foresight.

//No…haven’t thought about that. 🙂 Maybe 5-6 years down the line if I move back to India. //
you don’t have to be in india right? any internet terminal in any part of the universe will suffice.

//It’s a pity that they’re not allowing Indians to register for it anymore, because of the recent court case.//
thats because India tried to make its own CFA organization and create confusion… but this trend will pass.

//same here.. 6 months ago I used to trade a lot in derivatives.. but these days i stick to options. (but i trade only when i am dead sure about the trend)

Options is a type of derivative- it derives it’s value from the underlying stock. You’re contradicting yourself in that statement.

//you don’t have to be in india right? any internet terminal in any part of the universe will suffice.

Yeah, but I’m not really interested in the Indian stock market. 🙂

//low volume means that the buyer (you and I) can dictate the terms. there would be lots of guys who hold options contract at prices 20-30% off the current prices and want to square off their deal (booking profits/losses). All that is required is a guy who can spot them and offer to buy it at your own terms.

You’re talking about trading off the floor. That’s a different thing.

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