A story, I wrote a week ago, on whether our equity derivatives story is up to providing depth, liquidity, breadth and innovative products to investors for hedging and other uses during times of stress in the markets:
THE DOMESTIC EQUITY FUTURES AND OPTIONS MARKET: WHAT GOOD IS IT UP TO, REALLY?
The very beginning of the new calendar year has seen stock markets worldwide, including our own, grappling with a host of factors causing fear and pain. Under these difficult circumstances there is one equity market which tends to play the valuable role of a shock absorber: the equity derivatives market or the equity futures and options (F&O) market as it popularly known here.
To be sure, the domestic equity derivatives market is likely to play an important role as a shock absorber in case the Indian stock market keeps getting hit by the raised risk levels of global economic slowdown and the consequences of sustained currency devaluation by China. It plays the role of a buffer for foreign portfolio investors (FPIs), as well as domestic investors, where they can come to and execute their portfolio hedging strategies and other protection measures (see box: The most basic hedging strategy).
And, that role, being an ongoing role, is already being played out in the current month which has already seen two major bouts of market shocks involving sharp fall in global equity indices, including our Nifty 50 index and S&P BSE Sensex index.
The one which took place on Wednesday this week was the latest. According to Chandan Taparia, a senior technical analyst at Anand Rathi Broking’s retail research desk, FPIs were quick to take note of the heightened market volatility. He said the kind of buying in index options contracts which FPIs have done in the current month has not been seen in the past couple of years. “Since the start of the new month series this month, FPIs have been buying and selling in index options which we have not seen in the last few years. This indicates that the FPIs are doing two things – they are hedging in a big way and they are playing the volatility in he market,” he added.
Indeed, the domestic equity market ecosystem has had a robust equity derivatives (futures and options) market for most part of the last 16 years after it went live in June 2000 with initially only index futures trading. But given its current contours is the equity derivatives market micro-structure well placed to be an effective shock absorber?
FPIs have been selling in the equity cash market and in January their net outflows, as of January 20, was Rs 8,340 crore. They have been net sellers for the most part since May last year, monthly FPI net investment data put up by the National Securities Depository (under direction from the Securities and Exchange Board of India) shows. Barring July and November of 2015 the domestic equity market has witnessed FPI net outflows.
Have a look at the net outflow figures: Rs 5,770 crore in May, Rs 3,340 crore in June, Rs 16,880 crore in August, Rs 6,480 crore in September, Rs 7,070 crore in November and Rs 2,820 crore in December.
Clearly, therefore, the January (till 20) FPI net outflow level of Rs 8,340 crore, if it sustains around that level at the end of the month, would be the second-highest since May 2015 when the FPI net outflows in equities began.
While future forecasts, of whether global equity jitters will continue and whether it will lead to a meltdown in equity markets worldwide, may or may not get it right eventually. But what can help enormously is the ability of large investors such as the FPIs to be able to execute multiple trading strategies in the equity derivatives market to play out, temporarily, their portfolio protection strategies as well as any other which they want to execute to optimise their returns from the Indian equity market.
So, it that happening? “Yes,” says Siddharth Bhamre, head of derivatives and technical at Angel Broking, “No matter how large your portfolio is you can hedge in our equity derivatives market. There is enough liquidity in the Nifty F&O contracts as well as in 30-40 large-cap stocks in the stock F&O contracts.”
A FC Research Bureau analysis of Capitaline data on FPI investments in different types of equity F&O contracts revealed the exact numbers behind the assertion by Anand Rathi’s Taparia that FPIs were buying and selling in very large quantities in the current month as a response to the global market crash in the first week of January.
Our analysis shows that in the first 13 days of the new month series which began from January 1, and till January 19, the net buying action by FPIs in index options on the National Stock Exchange’s equity F&O segment was Rs 11,800 crore.
While this high level of net buying has been seen 3-4 times in the last 24 months, as per our analysis, what is unprecedented is the aggregate level of buying and selling by FPIs which was to the tune of Rs 3,84,100 crore in purchases and Rs 3,72,200 crore in sales.
It added up to a very large gross FPI trading value in index options of Rs 7,56,300 crore. The last biggest level in the last two years was in March last year, when the first 13 days of the new month series saw total FPI trades in index options to the tune of Rs 3,83,900 crore. The average monthly figure, in the analysed period, was Rs 2,75,700 crore.
The average daily traded value (including notional value for options contracts) in the entire equity F&O segment of NSE in January, till 21, was Rs 2,63,030 crore, which represented a jump of 25 per cent over the previous month’s average daily figure of Rs 2,10,500 crore. Index options notional turnover made up for 75 per cent of total turnover in the current month, till January 21, and averaged Rs 1,98,700 crore per day, which was 28 per cent more than the previous month’s average daily level.
This brings us to the mix of derivatives products available to large and small investors, institutional and retail, foreign or domestic. There are five equity F&O products available to investors, namely index futures, index options, stock futures, stock options, and volatility futures.
In the current financial year 2015-16 (FY16), till mid-January, 75 per cent of all equity F&O turnover on the NSE has been in index options, while stock futures’ share was 13 per cent, and those of index futures and stock options were 7 per cent and 5 per cent respectively.
According to Bhamre, for the institutional investor the futures contract is a better hedge than the options contracts. “Today, more than 80 per cent of trading is in options—index and stocks. The ideal mix would have been to have 60-65 per cent trades in options and the balance in futures.” Bhamre has a point if one looks at the historical mix on the NSE.
Index options had a share of just around 10 per cent during FY07 and FY08. This was, in fact, the last time when the domestic equity market had undergone a large fall on the back of global meltdown in financial markets following the global financial crisis. At that time stock futures was the pre-dominant traded derivatives instrument with a 50 per cent share, followed by about 30 per cent share of index futures.
Bhamre thinks the Indian investor psyche of not paying a higher rate of down-payment in the form of margins or any other means when entering into a forward contract is the reason why options has taken off in a big way. A futures trade attracts 10-15 per cent initial margin and also attracts a marked to market margin every day. In case of options, the buyer just pays a premium, which varies from 0.5 per cent to 3.0 per cent of the notional value of the trade. This is perceived by the lay investor as being cheaper by 5-10 times. The seller of options, of course, is subject to rigorous margins, including the marked-to-market options.
Another indicator of the action in equity F&O comes from the Sebi data giving investor category-wise share of turnover in equity derivatives. As per the latest monthly bulletin of Sebi, in the January-November 2015 period, the FPI share in NSE’s equity derivatives segment ranged from a low of 9.1 per cent in July to a high of 13.8 per cent in April. Proprietary account share of F&O brokers ranged from 47.7 per cent to 51.5 per cent, while individual (and other non-institutional investors) investor share ranged from 13.5 per cent to 15.9 per cent.
Mutual funds accounted for just 0.2 per cent to 0.7 per cent of the equity F&O turnover. Ideally, point out several market analysts, MFs should have been heavy users of the equity F&O market providing more depth and liquidity to it. But they have not taken to using the equity F&O market because a majority of the equity schemes of mutual funds have seen that they can get alpha returns from their cash market investments alone, and so they do not feel the need to protect their equity portfolios using F&O or to implement other investment strategies using F&O which can optimise their returns further.
The stock market regulator, Sebi, plays a major role as an active fiddler in the regulations governing the domestic equity F&O market. In the middle of last year, Sebi ordered that all new equity derivatives contracts getting introduced from the end of August-expiry contracts be subject to a new minimum trading lot size condition of Rs 5 lakh. Earlier, this was Rs 2 lakh.
This had the effect the tripling the minimum lot size in Nifty futures and Nifty options contracts, and turnover in the equity F&O volume fell in the last quarter of calendar 2015. “There were many investors who would take trading positions in just one or two trading lots,” said Bhamre. He said he advised his firm’s clients who still wanted to trade in the higher minimum lot sizes to take their trading to the cash market, they took to trading in options where the premiums cost 1-2 per cent even though they may been trading in futures in the earlier regime.
This has had the effect of pushing the options trading attractiveness still higher, and increasing their notional exposure to the market leading to higher risks from adverse fluctuations. Bhamre and other analysts believe the access to the equity F&O market should not be so restricted.
A few years back, in 2012, Sebi had tightened the criteria for a stock to be included in the stock F&O list which nearly halved the number of eligible stocks from around 182 to 130. In a research paper presented in December last year by four professors of Indian School Business and University of Southern California analysing the effect of the impact of the criteria change, it was concluded that prices of the excluded stocks, which did not meet the new critiera, were negatively impacted. The research paper argued that this was because when derivatives is allowed in a stock its price efficiency and liquidity increases. The study also concluded that contrary to the expectations of the regulators of cutting undue volatility in individual stocks, volatility largely remained unchanged after their exclusion from the F&O list.
In September last year, a finance ministry-appointed standing council had submitted its report on the international competitiveness of the Indian financial sector. It noted that Singapore’s SGX was the main competitor for Nifty index derivatives. It also said that foreign participation in the Indian equity derivatives markets is hampered by two elements of capital controls, (1) limitations on access and (2) fragmented markets.
In comparing domestic equity derivatives market’s competitiveness with that of SGX the report argued that low position limits in the domestic market constrained participation, especially that of large institutional players. “Position limits in equity derivatives are the higher of USD 83 million or 15% of market OI for futures and options separately. This implies a limit of USD 300 million for index futures and index options each. In comparison, position limits on SGX are USD 345 million on the buy side and the sell side each. While current position limits on NSE are comparable with SGX, stronger participation from domestic institutions and greater investments by domestic financial firms would make the market more robust.”
Clearly, there is more scope for the domestic equity F&O microstructure to transform into a better one and enable it to play the critical role of more efficient risk-transfer and hedging and thereby acting as vital shock absorbers during times of global jitters.
-------------------------------------------------------------------------------------------------------
THE MOST BASIC HEDGING STRATEGY
There are innumberable strategies deployed by investors, institutional and retail, in the equity derivatives market. But the most basic and simple of them are just two.
The put options hedge.
In this, the investor protects her portfolio or her holdings in a stock by buying put options on an index or the stock. The idea is to insure against a drop in the price of the portfolio or the stock, and is primarily used when the investor is confident of the fundamental of her portfolio or stock, but feels external market jitters will pull down the value of her portfolio or stock.
She seeks the protection for that much time only when she expects the external market shocks to occur. Once the event passes by or fails to occur during that estimated time period she lets her options expire. But till then she keeps rolling over her put options position around the month-end expiry date to the next near-month put options contract.
The cost of the hedge for the investor is the premium she pays to buy the put options which is roughly around 1-2 per cent of the notional value. Other than this cost, and the cost of the brokerage charge, there is no other cost. She gets to keep the entire upside, in case the index or stock does not fall, as she simply lets the options expire un-exercised. Her loss is the 1-2 per cent premium she paid.
If the index or stock does fall or crash, she gets to profit at the rate of the fall by exercising her options, in addition to seeing her portfolio or stock rise in value.
The futures hedge
As in the case of the put options hedge, the basic idea to hedge is the same. But there is a difference in the cost and the impact of the hedge.
In this strategy, the investor sells the index—or stock—futures. On the Indian equity F&O market, she pays an initial margin of 10-15 per cent on the value of the trade and also pays marked-to-market losses on her position till the time it is kept open.
Other than the cost of interest loss on the margin payments and the brokerage fee, there is no other cost. If the spot price of the index or stock falls, she profits to the extent of the rate of fall. Thus, her portfolio or stock value is protected from the fall because she is getting reimbursed to the extent of the loss due to the fall in the spot price.
However, if the stock or the index goes up, then she loses to the extent of the rate of price increase. But since the prices have risen, the value of her portfolio or stock has also gone up. So, she is essentially locking in her portfolio or stock at the spot price prevailing at the time of her futures trade.
Derivatives story ---- https://t.co/jM1WTzrjfU https://t.co/CHm7mGQE6q pic.twitter.com/VhRGEFFqm1
— Rajesh Gajra (@JournalistRGaj) January 23, 2016
(contd) Derivatives story ---- https://t.co/jM1WTzrjfU https://t.co/CHm7mGQE6q pic.twitter.com/OnvpDGede5
— Rajesh Gajra (@JournalistRGaj) January 23, 2016
The 2 most basic hedging strategies in equity futures & options -- https://t.co/ZdOlSdJJug pic.twitter.com/mukMmRwRbc
— Rajesh Gajra (@JournalistRGaj) January 23, 2016
THE DOMESTIC EQUITY FUTURES AND OPTIONS MARKET: WHAT GOOD IS IT UP TO, REALLY?
The very beginning of the new calendar year has seen stock markets worldwide, including our own, grappling with a host of factors causing fear and pain. Under these difficult circumstances there is one equity market which tends to play the valuable role of a shock absorber: the equity derivatives market or the equity futures and options (F&O) market as it popularly known here.
To be sure, the domestic equity derivatives market is likely to play an important role as a shock absorber in case the Indian stock market keeps getting hit by the raised risk levels of global economic slowdown and the consequences of sustained currency devaluation by China. It plays the role of a buffer for foreign portfolio investors (FPIs), as well as domestic investors, where they can come to and execute their portfolio hedging strategies and other protection measures (see box: The most basic hedging strategy).
And, that role, being an ongoing role, is already being played out in the current month which has already seen two major bouts of market shocks involving sharp fall in global equity indices, including our Nifty 50 index and S&P BSE Sensex index.
The one which took place on Wednesday this week was the latest. According to Chandan Taparia, a senior technical analyst at Anand Rathi Broking’s retail research desk, FPIs were quick to take note of the heightened market volatility. He said the kind of buying in index options contracts which FPIs have done in the current month has not been seen in the past couple of years. “Since the start of the new month series this month, FPIs have been buying and selling in index options which we have not seen in the last few years. This indicates that the FPIs are doing two things – they are hedging in a big way and they are playing the volatility in he market,” he added.
Indeed, the domestic equity market ecosystem has had a robust equity derivatives (futures and options) market for most part of the last 16 years after it went live in June 2000 with initially only index futures trading. But given its current contours is the equity derivatives market micro-structure well placed to be an effective shock absorber?
FPIs have been selling in the equity cash market and in January their net outflows, as of January 20, was Rs 8,340 crore. They have been net sellers for the most part since May last year, monthly FPI net investment data put up by the National Securities Depository (under direction from the Securities and Exchange Board of India) shows. Barring July and November of 2015 the domestic equity market has witnessed FPI net outflows.
Have a look at the net outflow figures: Rs 5,770 crore in May, Rs 3,340 crore in June, Rs 16,880 crore in August, Rs 6,480 crore in September, Rs 7,070 crore in November and Rs 2,820 crore in December.
Clearly, therefore, the January (till 20) FPI net outflow level of Rs 8,340 crore, if it sustains around that level at the end of the month, would be the second-highest since May 2015 when the FPI net outflows in equities began.
While future forecasts, of whether global equity jitters will continue and whether it will lead to a meltdown in equity markets worldwide, may or may not get it right eventually. But what can help enormously is the ability of large investors such as the FPIs to be able to execute multiple trading strategies in the equity derivatives market to play out, temporarily, their portfolio protection strategies as well as any other which they want to execute to optimise their returns from the Indian equity market.
So, it that happening? “Yes,” says Siddharth Bhamre, head of derivatives and technical at Angel Broking, “No matter how large your portfolio is you can hedge in our equity derivatives market. There is enough liquidity in the Nifty F&O contracts as well as in 30-40 large-cap stocks in the stock F&O contracts.”
A FC Research Bureau analysis of Capitaline data on FPI investments in different types of equity F&O contracts revealed the exact numbers behind the assertion by Anand Rathi’s Taparia that FPIs were buying and selling in very large quantities in the current month as a response to the global market crash in the first week of January.
Our analysis shows that in the first 13 days of the new month series which began from January 1, and till January 19, the net buying action by FPIs in index options on the National Stock Exchange’s equity F&O segment was Rs 11,800 crore.
While this high level of net buying has been seen 3-4 times in the last 24 months, as per our analysis, what is unprecedented is the aggregate level of buying and selling by FPIs which was to the tune of Rs 3,84,100 crore in purchases and Rs 3,72,200 crore in sales.
It added up to a very large gross FPI trading value in index options of Rs 7,56,300 crore. The last biggest level in the last two years was in March last year, when the first 13 days of the new month series saw total FPI trades in index options to the tune of Rs 3,83,900 crore. The average monthly figure, in the analysed period, was Rs 2,75,700 crore.
| FPIs dabbling in equity derivatives | ||
| FPIs increased their use of three of the four | ||
| derivatives instruments in CY15 over CY14 | ||
| CY14 | CY15 | |
| Index Futures - Buy | 2480 | 2575 |
| Index Futures - Sell | 2444 | 2601 |
| Index Options - Buy | 14451 | 16840 |
| Index Options - Sell | 14035 | 16290 |
| Stock Futures - Buy | 4879 | 5213 |
| Stock Futures - Sell | 5013 | 5188 |
| Stock Options - Buy | 2004 | 1869 |
| Stock Options - Sell | 2026 | 1888 |
| Figures in Rs crore, represent daily average | ||
| CY: calendar year | ||
| Source: Capitaline (source:Sebi). | ||
| Analysed by FCRB. | ||
The average daily traded value (including notional value for options contracts) in the entire equity F&O segment of NSE in January, till 21, was Rs 2,63,030 crore, which represented a jump of 25 per cent over the previous month’s average daily figure of Rs 2,10,500 crore. Index options notional turnover made up for 75 per cent of total turnover in the current month, till January 21, and averaged Rs 1,98,700 crore per day, which was 28 per cent more than the previous month’s average daily level.
This brings us to the mix of derivatives products available to large and small investors, institutional and retail, foreign or domestic. There are five equity F&O products available to investors, namely index futures, index options, stock futures, stock options, and volatility futures.
In the current financial year 2015-16 (FY16), till mid-January, 75 per cent of all equity F&O turnover on the NSE has been in index options, while stock futures’ share was 13 per cent, and those of index futures and stock options were 7 per cent and 5 per cent respectively.
According to Bhamre, for the institutional investor the futures contract is a better hedge than the options contracts. “Today, more than 80 per cent of trading is in options—index and stocks. The ideal mix would have been to have 60-65 per cent trades in options and the balance in futures.” Bhamre has a point if one looks at the historical mix on the NSE.
Index options had a share of just around 10 per cent during FY07 and FY08. This was, in fact, the last time when the domestic equity market had undergone a large fall on the back of global meltdown in financial markets following the global financial crisis. At that time stock futures was the pre-dominant traded derivatives instrument with a 50 per cent share, followed by about 30 per cent share of index futures.
| The historical mix | ||||||
| Stock-based derivatives' share fell from 30% to 20% in last few years | ||||||
| Share in total equity F&O turnover: | ||||||
| Index futures | Index options | Stock futures | Stock options | |||
| FY03 | 10 | 2 | 65 | 23 | 100 | |
| FY04 | 26 | 2 | 61 | 10 | 100 | |
| FY05 | 30 | 5 | 58 | 7 | 100 | |
| FY06 | 31 | 7 | 58 | 4 | 100 | |
| FY07 | 35 | 11 | 52 | 3 | 100 | |
| FY08 | 29 | 10 | 58 | 3 | 100 | |
| FY09 | 32 | 34 | 32 | 2 | 100 | |
| FY10 | 22 | 45 | 29 | 3 | 100 | |
| FY11 | 15 | 63 | 19 | 4 | 100 | |
| FY12 | 11 | 72 | 13 | 3 | 100 | |
| FY13 | 8 | 72 | 14 | 6 | 100 | |
| FY14 | 8 | 73 | 13 | 6 | 100 | |
| FY15 | 7 | 72 | 15 | 6 | 100 | |
| FY16 | 7 | 75 | 13 | 5 | 100 | |
| Figures in per cent, represent share in total equity equity F&O turnover | ||||||
| Put a * in FY16, and say the following in the footnote *till mid-January | ||||||
| Source: National Stock Exchange. Analysed by FC Research Bureau | ||||||
Bhamre thinks the Indian investor psyche of not paying a higher rate of down-payment in the form of margins or any other means when entering into a forward contract is the reason why options has taken off in a big way. A futures trade attracts 10-15 per cent initial margin and also attracts a marked to market margin every day. In case of options, the buyer just pays a premium, which varies from 0.5 per cent to 3.0 per cent of the notional value of the trade. This is perceived by the lay investor as being cheaper by 5-10 times. The seller of options, of course, is subject to rigorous margins, including the marked-to-market options.
Another indicator of the action in equity F&O comes from the Sebi data giving investor category-wise share of turnover in equity derivatives. As per the latest monthly bulletin of Sebi, in the January-November 2015 period, the FPI share in NSE’s equity derivatives segment ranged from a low of 9.1 per cent in July to a high of 13.8 per cent in April. Proprietary account share of F&O brokers ranged from 47.7 per cent to 51.5 per cent, while individual (and other non-institutional investors) investor share ranged from 13.5 per cent to 15.9 per cent.
Mutual funds accounted for just 0.2 per cent to 0.7 per cent of the equity F&O turnover. Ideally, point out several market analysts, MFs should have been heavy users of the equity F&O market providing more depth and liquidity to it. But they have not taken to using the equity F&O market because a majority of the equity schemes of mutual funds have seen that they can get alpha returns from their cash market investments alone, and so they do not feel the need to protect their equity portfolios using F&O or to implement other investment strategies using F&O which can optimise their returns further.
The stock market regulator, Sebi, plays a major role as an active fiddler in the regulations governing the domestic equity F&O market. In the middle of last year, Sebi ordered that all new equity derivatives contracts getting introduced from the end of August-expiry contracts be subject to a new minimum trading lot size condition of Rs 5 lakh. Earlier, this was Rs 2 lakh.
This had the effect the tripling the minimum lot size in Nifty futures and Nifty options contracts, and turnover in the equity F&O volume fell in the last quarter of calendar 2015. “There were many investors who would take trading positions in just one or two trading lots,” said Bhamre. He said he advised his firm’s clients who still wanted to trade in the higher minimum lot sizes to take their trading to the cash market, they took to trading in options where the premiums cost 1-2 per cent even though they may been trading in futures in the earlier regime.
This has had the effect of pushing the options trading attractiveness still higher, and increasing their notional exposure to the market leading to higher risks from adverse fluctuations. Bhamre and other analysts believe the access to the equity F&O market should not be so restricted.
| Cash vs derivatives in equity market | |||
| Lower margins and downpayment have inevitably meant higher | |||
| notional turnover in F&O | |||
| Total turnover (Rs crore) | |||
| Cash market | Derivatives market | Derivatives over cash (times) | |
| FY13 | 3257000 | 38697000 | 11.9 |
| FY14 | 3348000 | 47431000 | 14.2 |
| FY15 | 5185000 | 75969000 | 14.7 |
| FY16 (Apr-Dec) | 3724923 | 50590399 | 13.6 |
| Figures represent total traded value in the cash market and notional | |||
| turnover in the derivatives market | |||
| Data covers NSE and BSE | |||
| Source: Sebi, NSE, BSE. Analysed by FCRB | |||
A few years back, in 2012, Sebi had tightened the criteria for a stock to be included in the stock F&O list which nearly halved the number of eligible stocks from around 182 to 130. In a research paper presented in December last year by four professors of Indian School Business and University of Southern California analysing the effect of the impact of the criteria change, it was concluded that prices of the excluded stocks, which did not meet the new critiera, were negatively impacted. The research paper argued that this was because when derivatives is allowed in a stock its price efficiency and liquidity increases. The study also concluded that contrary to the expectations of the regulators of cutting undue volatility in individual stocks, volatility largely remained unchanged after their exclusion from the F&O list.
In September last year, a finance ministry-appointed standing council had submitted its report on the international competitiveness of the Indian financial sector. It noted that Singapore’s SGX was the main competitor for Nifty index derivatives. It also said that foreign participation in the Indian equity derivatives markets is hampered by two elements of capital controls, (1) limitations on access and (2) fragmented markets.
| India's equity F&O vs world's | ||||
| Size of Indian equity derivatives market is formidable and compares well with the world total | ||||
| NSE's share in world total (%) | BSE's share in world total (%) | |||
| No. of contracts | Notional turnover | Number of contracts | Notional turnover | |
| Index futures | 6.0 | 0.4 | Negligible | Negligible |
| Index options | 48.7 | 5.5 | 4.2 | 0.9 |
| Stock futures | 26.1 | 27.4 | Negligible | Negligible |
| Stock options | 3.1 | 10.6 | 0.2 | 0.7 |
| For notional turnover, share is derived from US$ notional value of trades | ||||
| Source: World Federation of Exchanges. Analysed by FCRB. | ||||
Clearly, there is more scope for the domestic equity F&O microstructure to transform into a better one and enable it to play the critical role of more efficient risk-transfer and hedging and thereby acting as vital shock absorbers during times of global jitters.
-------------------------------------------------------------------------------------------------------
THE MOST BASIC HEDGING STRATEGY
There are innumberable strategies deployed by investors, institutional and retail, in the equity derivatives market. But the most basic and simple of them are just two.
The put options hedge.
In this, the investor protects her portfolio or her holdings in a stock by buying put options on an index or the stock. The idea is to insure against a drop in the price of the portfolio or the stock, and is primarily used when the investor is confident of the fundamental of her portfolio or stock, but feels external market jitters will pull down the value of her portfolio or stock.
She seeks the protection for that much time only when she expects the external market shocks to occur. Once the event passes by or fails to occur during that estimated time period she lets her options expire. But till then she keeps rolling over her put options position around the month-end expiry date to the next near-month put options contract.
The cost of the hedge for the investor is the premium she pays to buy the put options which is roughly around 1-2 per cent of the notional value. Other than this cost, and the cost of the brokerage charge, there is no other cost. She gets to keep the entire upside, in case the index or stock does not fall, as she simply lets the options expire un-exercised. Her loss is the 1-2 per cent premium she paid.
If the index or stock does fall or crash, she gets to profit at the rate of the fall by exercising her options, in addition to seeing her portfolio or stock rise in value.
The futures hedge
As in the case of the put options hedge, the basic idea to hedge is the same. But there is a difference in the cost and the impact of the hedge.
In this strategy, the investor sells the index—or stock—futures. On the Indian equity F&O market, she pays an initial margin of 10-15 per cent on the value of the trade and also pays marked-to-market losses on her position till the time it is kept open.
Other than the cost of interest loss on the margin payments and the brokerage fee, there is no other cost. If the spot price of the index or stock falls, she profits to the extent of the rate of fall. Thus, her portfolio or stock value is protected from the fall because she is getting reimbursed to the extent of the loss due to the fall in the spot price.
However, if the stock or the index goes up, then she loses to the extent of the rate of price increase. But since the prices have risen, the value of her portfolio or stock has also gone up. So, she is essentially locking in her portfolio or stock at the spot price prevailing at the time of her futures trade.
