How to Hedge Using Futures: A Risk Management Strategy for Smart Traders

In the trading world, hedging is a strategy to protect your investment against adverse price movements. It's a defensive approach where traders or investors open an opposite position in a related asset to minimize the potential impact of market volatility. 

Among various tools available for hedging, futures contracts are widely used. Other instruments include forwards and options, but for this discussion, we'll focus specifically on how futures can be used as a hedging tool, especially by users of platforms like m.Stock. 

How Does Hedging Work? 

Let’s break it down with an example to understand the hedging process more clearly: 

Assume you own 100 shares of ABC Ltd, currently trading at ₹100 per share. You have a long-term bullish outlook on the company and wish to retain your holdings. However, you anticipate a short-term decline in the stock's price due to the upcoming retirement of the company’s CEO. 

Now, while your long-term belief remains unchanged, you're concerned about near-term volatility and want to protect your portfolio value. 

To hedge this position, you decide to use the futures market. 

Hedging in Action: Using Futures Contracts 

Let’s say that: 

• 1 lot of ABC Ltd = 100 shares 

• You short 1 futures lot of ABC Ltd at ₹100 

This creates a perfect hedge where your cash holding is balanced by a matching short position in futures. (Note: Perfect hedges are rare in practice, but this simplified example helps to illustrate the concept.) 

Now let’s look at two possible market scenarios: 

 Scenario 1: ABC Ltd Falls to ₹90 

• Cash position: You lose ₹10 × 100 shares = ₹10,000 

• Futures position: You gain ₹10 × 100 shares = ₹10,000 

Net effect: Your loss in the cash market is fully offset by your profit in futures. The only cost incurred is the transaction fee of executing the hedge. 

Scenario 2: ABC Ltd Rises to ₹110 

• Cash position: You gain ₹10 × 100 shares = ₹10,000 

• Futures position: You lose ₹10 × 100 shares = ₹10,000 

Net effect: Your gain in the spot market is neutralized by the futures loss. Again, the net result is near zero, aside from transaction costs. 

Hedging vs Speculation: Know the Difference 

Understanding the difference between hedging and speculation is key: 

• Hedging aims to reduce risk. It’s defensive, done to protect existing investments from unfavorable movements. 

• Speculation is about taking on risk for potential gains. It’s aggressive, done in anticipation of making a profit from price fluctuations. 

As an investor on m.Stock, using futures for hedging can be a practical way to manage market uncertainty while staying committed to long-term investment goals. 

Key Takeaways: 

• Hedging helps manage downside risk by taking an opposite position using futures. 

• Futures contracts are effective tools for portfolio protection in volatile markets. 

• A perfect hedge can offset all losses in the cash market, but may also cap gains. 

• Always differentiate between risk mitigation (hedging) and profit-seeking (speculation).