Mutual fund Manager occasionally Hedge their portfolio, in order to protect their portfolio from extreme risk. In our life, we also minimize our risks by taking medical, life, or house etc. type of insurances. The same way portfolio Hedging is done by taking an insurance for the portfolio so that any extreme risks could be avoided.

When is hedging required?

Hedging is required whenever markets are anticipating any major event and there is a lot of uncertainty in it. In Indian economy context, we had major events like demonetization, UP elections, bank recapitalization and currently having Gujarat elections. All these events played a crucial role in markets. These type of events make or break Investors confidence thereby markets become bullish or bearish. In case of extreme bearish news, all the profits of the portfolio could be wiped out in a day, therefore hedging is extremely important. It is important for survival in markets.

How to Hedge portfolio?

In order to prevent losses, portfolio or fund managers buy or sell options or futures depending on the strategy they are following.

Here is an example:

Current Market Condition: Nifty: 10000, Major news coming regarding elections and the market are anticipating the current government will win and continue until 2022.

Actions taken by Fund Manager: He brought Nifty put option with a strike price, 9900 (Nifty 9900 PE). If the market goes below 9900, the portfolio will be no profit no loss situation as the purchased option will compensate the loss occurred by your portfolio.

Next days News: Nifty: 9850 Result announced and current government lost in elections. The markets took this as extremely bad condition and most of the investors became pessimistic about the future developments in the country.

Benefits of Hedging: As a result of market crashing, the portfolio is in the loss but portfolio manager had brought Nifty 9900 PE.  Now, the premium or price of Nifty 9900 PE has gone up and overall losses are minimized.

Important point: Any insurance policy comes in coverage or insured amount. Therefore the person who is taking insurance needs to consider all the risk involved and choose correct coverage of insurance policy. The same way a portfolio manager has to decide the amount of hedging required for the portfolio.

The amount of hedging required depends on

  1. The Portfolio size
  2. The degree of uncertainty in the market.

Now comes the important question, How to anticipate such market downfall is coming?

Fund manager needs to keep a watch on global cues, major events and some rumours hovering around markets. Therefore it is a day to day job and needs an attention.

Read: Do you regret selling any stock?

Read: Why do we consider the Stock Market with gambling?