InvestorQ : What are some simple ways in which I can hedge my equity market risk in a way that is not too expensive for me?
Rutuja Nigam made post

What are some simple ways in which I can hedge my equity market risk in a way that is not too expensive for me?

Arti Chavan answered.
4 years ago

There are various ways to do it. For started you can look to hedging risk using Index Futures. It is quite simple and here is how it works. Selling index futures against your portfolio holdings is the simplest way of hedging your risk. Here is how it works. Assume that you have an equity portfolio of Rs.52 lakhs. The value of 1 lot of Nifty is approx Rs.7.50 lakhs at current levels and you can hedge your portfolio by selling 7 lots (525 Nifty units) of Nifty futures. Your portfolio may not be perfectly correlated with the Nifty so this is not perfect hedge. The idea here is to protect downside risk in the event of any external disruptions to your portfolio. Having sold Nifty futures, there are two scenarios that are possible. Firstly, the Nifty may move up from current levels. That will lead to losses on Nifty Futures (since you have sold Nifty futures), but the value of your equity portfolio will have most likely gone up. Of course, you can also do a Beta hedge against your entire portfolio by selling equivalent Nifty futures and that is a lot simpler. For example, let us assume that the US and Russia come to loggerheads over North Korea and Nifty corrects by 4% in a single day. Obviously, the value of your stock portfolio will be down. But, since you have sold Nifty Futures, you will make a profit on Nifty Futures. Thus your hedge not only protects, but also helps you profit from the volatility.

Secondly, you can also hedge your risk using Index Put options. That is a lot more interesting and asymmetric and works in favour of the put buyers. Put Options are slightly different from futures in that they represent a “right to sell, but not an obligation to sell”. When you buy put options on the Nifty, you get a right to sell the Nifty but not an obligation to sell the Nifty. For this privilege you have to pay a small price which is called the option premium. Considering the current volatility, if you can protect your portfolio from 5% volatility, then a cost of 1% is surely worth it.

At a slightly more allocation level, you can simply hedge by purchasing gold as an asset class. This may not be a very scientific way of hedging your portfolio, but it will work nevertheless. Remember, gold is a safe-haven investment. That means, in times of geopolitical risk gold is in demand and therefore you will see a rise in the price of gold. We saw that in the midst of the economic uncertainty in early 2016 when gold rallied by over 25% in less than 6 months. The notional loss in equity can be partially compensated by shifting a part of your equity portfolio into gold (prefer non-physical gold). This will not only save you from the volatility, but will also help you profit from gold and use the liquidity to buy back equities at lower prices. A very important consideration in this strategy will be the tax. There will be a tax implication when you churn equities and also when you churn gold. You need to factor that before evaluating the efficacy of this strategy. Gold gets taxed at a much higher rate compared to equities, unless of course you buy gold bonds and hold it for full tenure in which case it is free from capital gains tax.