Hedging involves buying or selling futures contracts to protect against losses caused by price changes in the cash market. Think of it as an insurance policy. Given the volatility of the financial market, hedging with futures and options plays a crucial role that cannot be overlooked.
In fact, the global volume of futures and options contracts rose to a record high of 137 billion in 2023. Surprisingly, the Asia-Pacific region held the largest trading share, with contract volumes reaching 103.5 billion—India being a key contributor to this growth.
Investors and businesses should take advantage of this growth to manage their exposure to volatile prices. This approach can be a game changer, driving profits while safeguarding portfolios from unpredictable market conditions.
In this guide, we’ll explore different hedging techniques using futures and options. Read on to learn how to unlock the benefits these investment opportunities present.
How to Hedge Using Futures and Options
1. Hedging Using Futures
When using futures, you protect yourself against unfavorable changes in asset prices. Futures hedging allows you to smooth out fluctuations in asset prices. Here, you are obligated to buy or sell the underlying asset, either through a short or long hedge.
- Short Hedge: A short hedge involves taking a short position in a futures contract. In simpler terms, a hedger takes this position when they expect to sell an asset in the future. Speculators can also use a short hedge if they anticipate a decrease in the contract price.
- Long Hedge: A long hedge involves taking a long position to manage risk. For instance, if you plan to buy soybeans in the future and the price increases, you will be negatively affected. To mitigate this risk, you can use a long hedge.
Let’s explore the advantages of hedging with futures contracts:
- Highly Leveraged: You only need to pay an initial margin, which is a small fraction of the asset’s value, to trade in futures. This guarantees that the investor maintains their position. While potential losses can exceed the margin, there is also the potential for high profits if asset prices move as anticipated. This leverage allows you to trade large quantities of assets even without the full amount.
- Market Liquidity: Since futures are traded in large amounts daily, the market is highly liquid, ensuring buyers and sellers are readily available, and orders are executed quickly.
- Quick Cash: Compared to stocks, futures provide faster access to cash due to their higher exposure. While the potential for large and fast profits exists, the volatility can also increase the likelihood of losses.
- Higher Gains: Investors can benefit from short-term price fluctuations, although this comes with a higher risk.
- Risk Management: Futures hedging helps manage risks related to interest rates and foreign exchange, particularly for international trades.
2. Hedging Using Options
An option gives you the right, but not the obligation, to buy or sell a futures contract at a specific price by a certain date. Options can be either a call or a put option.
- Call Option: A call option gives the buyer the right to take a long position on a futures contract before or at the expiration date. For example, a December Soybean INR 300 call option gives the buyer the right to buy a futures contract for INR 300 between the purchase date and its expiration in November. Even if the price rises above INR 300, the buyer retains the right to buy at INR 300.
- Put Option: A put option gives the seller the right to sell a futures contract before or at the expiration date. Even if the price drops, the buyer holds this right.
Let’s explore the advantages of using options for hedging:
- Flexibility: With options, you are not obligated to execute the contract, giving you more flexibility in managing your market position.
- Limited Risk: As a buyer, your maximum loss is limited to the premium paid, while your potential profits are unlimited.
- Tailored Strategies: Options offer a variety of strategic opportunities, such as covered calls and straddles.
- Volatility Coverage: Options help hedge against price volatility, allowing you to benefit from dynamic market conditions.
- Cost Leverage: Advanced option trading strategies allow you to lower upfront costs, which can then be leveraged for increased returns.
How Short Hedging with Options Differs from Futures
When you sell a futures contract, you are bound by the price. However, when you purchase a put option, you have the right to sell the futures contract at the exercise price without being bound. Additionally, when you buy a put option, you pay a single premium upfront. Unlike futures contracts, options do not require a margin account during the option’s term.
What to Consider When Hedging with Futures and Options
- Avoid Overhedging: Overhedging can introduce more risk than anticipated and reduce profits.
- Ensure Liquidity: When entering either contract, ensure sufficient liquidity to minimize price impacts and avoid unnecessary delays.
- Evaluate OTC Contracts: Over-the-counter (OTC) contracts can help mitigate counterparty risks.
- Consider Future Rolling Costs: When entering new contracts, factor in future rolling costs as they may reduce potential profits.
- Adjust Techniques Periodically: Modify your hedging strategies to align with dynamic price shifts and market volatility.
Key Takeaways for Hedging with Futures and Options
Mastering hedging techniques with futures and options gives you a significant advantage in mitigating the risks posed by unpredictable market shifts. These strategies allow you to protect your portfolio from price changes while seizing market opportunities.
Findoc can help you monitor the market and align your trading strategies to meet market needs. Avoid common mistakes when trading futures to safeguard your portfolio. Invest in futures and options today.
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