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Locking in gains using OPTIONS — Strategies to hedge equity risk

Srividhya Sivakumar

Dabbling in derivatives can be very risky. However, when used for hedging, the same instruments help reduce the risk an investor bears when stock prices fall. Investors of all descriptions, with the help of options, can hedge their equity investments and protect them from potential declines in stock prices.

While investments made with a short-term horizon are, by nature, more susceptible to market vagaries, long-term investments too cannot remain unscathed when markets turn extremely volatile.

How can derivatives be used to hedge equity risk? When should a hedge be created? How can idle long-term stock holdings be used to lock in gains? Here are a few strategies that apply in different situations:

Insurance against downside

Consider this. Markets are at an all time high. Your portfolio value too has appreciated considerably. If you are worried that the stock prices will fall in the near future or that volatility in the broad markets can wipe out some of your gains, portfolio-hedging can come in handy.

This can be implemented by buying index put options, which gain in value with every fall in the markets. But how may puts do you need to buy to protect your portfolio?

Say, you hold 1,000 shares of Bharti Airtel, 300 shares of Infosys, 500 shares of Reliance Industries and 700 shares of Hindustan Unilever. In order to completely hedge the portfolio, you need to arrive at the total beta value of your holdings. To begin with, get the beta of individual stocks against the index (available in NSE monthly newsletters).

Now, multiply individual beta value of stocks to the current value of investment in that stock. Then, divide the sum of all these numbers with the total value of your investment (current) to arrive at the overall beta of your portfolio.

Typically, ‘Beta’ captures the extent to which the value of your portfolio will change with every movement in the index; higher the beta, higher the correlation with the index.

To calculate the number of puts you need to buy, multiply the current value of your investment with portfolio beta and then divide that by the Nifty value (arrived at by multiplying Nifty spot by its lot size). Say the Nifty spot value is at 5200.

Now, if you want to hedge your portfolio against any drop of more than 10 per cent, you should buy puts with 4680-spot price.

Possible outcomes: Now if the market falls below 4680, the index puts will turn ‘in-the-money’, and gains made through the options will make up for the notional loss in portfolio value.

On the contrary, if the market does not correct, as you had feared, then the puts will expire worthless. However, in such a scenario, the premium paid for securing the puts would be a one-time pay out and would be the cost of insuring your portfolio.

Note that brokerage commissions and other charges have not been included. Investors, however, will have to include such charges to arrive at optimum spreads.

Preserving your wealth

Hedging can also be used when you hold a large chunk of a specific company’s shares, either earned as ESOPs or accumulated over the years. In such a scenario, your cost of investment might be significantly lower than the current value of your holdings.

However, if your financial goal involves selling these shares in near future, you could be better off creating a hedge, to lock in a certain minimum level of gains. There are different ways to hedge your portfolio and profit from these idle holdings of a single stock.

If the stock you hold is being traded in the derivatives segment, buying stock puts can create a good hedge.

Again, the spot price of the option will depend on the minimum sale price you intend to secure for your shares (or the percentage of loss that you can tolerate).

Alternatively, if you are confident on the stock prospects (for the period of the contract) but are concerned that broad market volatility could weigh on the stock performance, buying Nifty puts can be considered.

Depending on the stock beta and the hedge required, you can arrive at the number of Nifty puts that should be bought. This way, you can minimise the influence of Nifty on your stock performance.

Covered calls

This strategy involves selling ‘out-of-money’ call options in a stock, while simultaneously holding an equivalent position in the underlying.

Covered call can be written when you are bullish on the underlying stock over the long term but feel that the stock price will trade in a tight range over the lifetime of the contract.

Remember that writing a call gives the buyer the right, and not the obligation, to buy shares from you at the specified price, on or before the stipulated time period. Say, you hold 1,000 shares of Infosys. You are bullish on the long-term prospects of the company but feel that given the rupee appreciation and sub-prime concerns the stock might trade sideways for the next one month.

Depending on what you foresee as the upper trading range of the stock (say, it is Rs 2,200), you can consider selling calls at that spot price. However, note that you stand the risk of not finding takers for your calls if they are sold with unrealistically high spot prices.

Possible outcomes: If the stock trades flat, the option will expire worthless and you get to keep the premium. Similarly, even if the stock price falls, the options expire worthless.

In both these scenarios, you get to pocket the premium, which will help you outperform the stock returns in the cash market.

However, if the stock price were to rise beyond the spot price, you will have to part with your shares since the options will be exercised. In this case, your upside is capped at Rs 2,200, plus the premium you received.

Writing covered calls helps investors sitting on idle long-term holdings generate additional gains linked to these shares, provided you can forecast a trading range. This apart, it also secures the downside risk for the stock to an extent.

Moreover, since it requires writing calls only against an equivalent equity holding, it is also not very risky.

Nevertheless, investors stand the risk of parting with their stocks if the stock price were to move above the upper limit of the trading range. In such a case they also stand to lose out on any upside potential in the stock in the cash market.

Using a “protective collar”

Alternatively, you can also use ‘Protective Collar’, a strategy that will provide short-term downside protection to your stock holdings. Interestingly, this strategy, unlike the previous two, can be created at little or no cost at all.

Creating a collar requires you to buy puts on the stocks at lower spot prices and sell calls of the stock for the same month, but for a higher spot price.

Say, you hold 100 shares of ABC shares trading at Rs 1,900. Your cost of purchase for the stock was significantly lower, at Rs 200. So, on a per share basis, you are sitting on a profit of Rs 1,700.

Therefore, when you buy ABC put options with a strike price of 1,800, which trades at, say, Rs 35 per lot, you will lock in gains of Rs 1,665 per share (1,700-35). Remember that you will have to shell out Rs 3,500 for securing this position (35*100, the lot size).

This will now limit your downside risk.

The second part of the strategy is to sell call options (that is, write calls) on the stock at a higher spot price. Assume you sell ABC call option with a strike of 2100 at Rs 44 per lot.

This position will earn you an initial sum of Rs 4,400. In this way, you net in a total of Rs 900 for creating the collar (Rs 4,400-3,500). The position now caps the maximum downside risk at about 5 per cent and upside potential (for the contract period) at 11 per cent.

Note that different spreads can be chosen, depending on the investors’ stock price outlook and risk tolerance.

Possible outcomes: If the stock price falls much below the strike price of the put option, gains from the long put position will offset the notional loss in portfolio value. The calls, however, will expire worthless. In addition to this, investors also get to pocket the gains that were made to create the collar.

If the stock price rises beyond the strike price of the call options, it will result in a loss. This loss will be offset by the rise in value of the stock holding. The put option will expire worthless. However, investors stand the risk of their calls being exercised, in which case they could be forced to part with their stock holdings.

If the stock price trades in a range between the put strike price of Rs 1,800 and the call strike price of Rs 2,100, both the options expire worthless. In this case, you gain only the money made from setting up the option spread.

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Locking in gains using OPTIONS — Strategies to hedge equity risk