Derivatives and advanced market conceptsModule 4, lesson 16 of 21
Hedging with derivatives
Hedging a portfolio with index futures or put options, sizing the hedge with beta, what protection costs, and why real hedges are imperfect.
In this lesson
- Explain how a short index futures position offsets falls in a share portfolio.
- Size a futures hedge using portfolio value, beta and contract value.
- Compare hedging with futures and with put options, including what each costs.
- Explain why hedges are imperfect and are never free.
Builds on
- The risks of buying and selling optionsHedging with puts means being an option buyer, with the costs explained there.
- Beta and market riskBeta is used to size the hedge.
On this page
In simple terms
Hedging means taking a position designed to gain when your existing holdings lose. It reduces risk rather than seeking profit. Derivatives were invented largely for this purpose: moving risk from people who do not want it to people willing to carry it for a price.
This lesson uses a share portfolio as the example, with made-up contract values.
Hedging with index futures
If you hold a portfolio of shares and fear a market fall, you can sell index futures. If the market falls, the short futures gain, offsetting the portfolio's loss.
Sizing the hedge. A portfolio's sensitivity to the market is measured by its beta, as the beta lesson explains.
Worked example: A made-up futures hedge
| Item | Value |
|---|---|
| Portfolio value | ₹20 lakh |
| Portfolio beta | 1.2 |
| Index futures contract value (made up) | ₹10 lakh |
| Market exposure: 20 × 1.2 | ₹24 lakh |
|---|---|
| Contracts needed: 24 ÷ 10 | 2.4 |
| Contracts sold, in whole numbers | 2 |
| Market move | Portfolio (beta 1.2) | Two short futures | Net |
|---|---|---|---|
| −10% | −₹2.4 lakh | +₹2.0 lakh | −₹0.4 lakh |
| +10% | +₹2.4 lakh | −₹2.0 lakh | +₹0.4 lakh |
The hedge removes most of the market's effect in both directions. The investor is protected from the fall but gives up most of the gain.
Futures hedges also need margin and face daily mark-to-market, as the futures margin lesson explains: in a rising market, losses on the futures must be paid in cash every day, even though the portfolio is gaining.
Hedging with put options
Buying put options on an index works like insurance: the puts gain if the market falls below the strike, while the portfolio keeps its upside if the market rises.
Worked example: The cost of put protection
Suppose, for this example, that puts covering ₹24 lakh of market exposure cost 1.5% of that exposure for three months.
| Cost for three months: 0.015 × 24 | ₹36,000 |
|---|---|
| Cost for a year if renewed each quarter | ₹1,44,000 |
| As a share of the ₹20 lakh portfolio | 7.2% a year |
Protection bought continuously can cost more than the portfolio's long-run expected return. Put prices also rise when markets are falling and fear is high, as the volatility lesson explains, so protection is most expensive when it is most wanted.
Why hedges are imperfect
- Whole contracts: the hedge is rarely the exact size needed.
- Beta changes: a portfolio's beta estimated from the past may not hold in a crisis.
- Specific risk: an index hedge does not protect against problems in individual companies, as the diversification lesson explains.
- Basis: futures and the index do not move exactly together before expiry, as the basis lesson explains.
- Rolling costs: hedges must be renewed at each expiry, with costs each time.
Hedging versus asset allocation
For most long-term investors, the simplest way to reduce risk is to hold less equity and more fixed income, as the asset allocation lesson explains. Derivative hedges suit specific situations, such as protecting a large concentrated holding for a short period, and require understanding, monitoring and cash for margin.
Why it matters
Hedging is the most legitimate use of derivatives, and the most misunderstood. Knowing how to size a hedge and what it costs shows why "free protection" does not exist, and why reducing risk usually also reduces return.
Limitations
The examples use made-up contract values and costs and ignore taxes and brokerage. Real hedges must account for contract specifications, margin rules and liquidity, which are set by exchanges and change over time.
Common mistakes
- Treating a hedge as free protection.
- Ignoring beta when sizing a hedge.
- Forgetting the cash needed for futures margin in a rising market.
- Expecting an index hedge to protect against a single company's problems.
Try it yourself
- For a ₹15 lakh portfolio with a beta of 0.9 and a made-up contract value of ₹7.5 lakh, calculate the number of contracts needed.
- Work out the net result of the hedge if the market falls 15% and if it rises 15%.
- Estimate the yearly cost of put protection at 2% of exposure per quarter, as a share of the portfolio.
Key takeaways
- Hedging means taking a position that gains when your existing holdings lose, to reduce overall risk.
- A short index futures position offsets market falls, but also gives up market gains. It removes most market risk, not the risk of individual shares.
- Hedge size is roughly portfolio value times beta, divided by the futures contract value. Contracts come in whole numbers, so hedges are rarely exact.
- Buying put options protects against falls while keeping the upside, at the cost of the premium, which adds up over time.
- Every hedge has a cost, in premium, in gains given up, or in imperfect matching. A hedge is not free protection.
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Terms used in this lesson
- Hedging
- Taking an offsetting position, such as a forward contract, to reduce the effect of a price or currency move on future payments or receipts.
- Beta
- A measure of how much a share's returns have moved with the overall market's, used in the capital asset pricing model.
- Put option
- A contract giving the buyer the right, but not the obligation, to sell the underlying at the strike price.
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This lesson is general education, not investment advice. Examples use made-up or clearly dated figures to explain ideas; they are not recommendations. Read the disclaimer.