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Futures Hedging

Hedging with Futures​

Hedging is a strategy used to protect your trading positions from adverse market movements. It involves taking an opposite position in the futures market to offset potential losses in your portfolio. For AlgoTest users, this concept is critical for building balanced strategies in the Strategy Builder or testing how a hedged position would perform using the Simulator.

What is Hedging?​

Imagine you’ve built a portfolio of stocks that you believe will grow over time. However, you anticipate short-term market volatility that could temporarily reduce the value of your holdings. Rather than selling your stocks, you can use futures contracts to hedge against these potential losses.

Example of Hedging​

Let’s say you own 250 shares of Infosys at ₹2,284 per share, worth ₹571,000 in total. You expect Infosys’ quarterly results to be unfavorable, which may lead to a drop in the stock price. Instead of selling your shares, you enter a short position in Infosys futures. By shorting 250 Infosys futures at ₹2,285, you create a hedged position.

Now, regardless of whether Infosys rises or falls, the gains and losses from your long position in the stock and your short position in the futures contract will offset each other. If Infosys’ stock price drops to ₹2,200, you’ll incur a loss on the stock but gain from your short futures position.

Systematic and Unsystematic Risk​

Hedging protects against systematic risk, which is the risk associated with overall market movements (like economic downturns, interest rate hikes, etc.). However, it does not protect against unsystematic risk, which is company-specific (such as poor earnings reports or management scandals).

How to Hedge with Futures on AlgoTest​

In the Strategy Builder, you can create strategies that hedge your stock portfolio using Nifty Futures or individual stock futures. For example, if you have a diversified stock portfolio worth ₹8,00,000, you can calculate the beta (sensitivity to market movements) of your portfolio. If your portfolio beta is 1.2, you can hedge the portfolio by shorting Nifty futures to offset market risk.

Calculating the Hedge Value​

  1. Calculate the Portfolio Beta by summing the weighted beta of each stock.
  2. Determine the Hedge Value by multiplying the Portfolio Beta by the total portfolio value.
  3. Calculate the Required Futures Lots using the Nifty Futures contract value.

Example:
If your hedge value is ₹9,78,400, and one Nifty futures contract is worth ₹2,25,625, you’d need to short about 4.33 lots of Nifty futures to fully hedge your portfolio. Since fractional lots are not available, you can short either 4 or 5 lots, knowing that you’ll be slightly under or over-hedged.

Conclusion​

Hedging with futures provides a way to protect your portfolio from market downturns, making it a valuable tool for AlgoTest users looking to manage risk. By using the Simulator, you can test different hedging strategies and fine-tune your approach based on real historical data.