How to hedge your portfolio against downturn

The Sensex now is just 7% away from its all time high of 42,273 hit on 20 January. However, there is a clear disconnect between the market rally and the stock fundamentals.What should investors do? First, restrict your portfolio to fundamentally strong companies that are still quoting at attractive valuations. Since 2020-21 is an abnormal year, it is reasonable to ignore these results. However, investors should look at the earnings growth expected in 2021-22. Second, book partial profits and sit on the sidelines for some time. Technical patterns have also started showing weakness. “Nifty is showing a broadening pattern and we are close to the upper end of that pattern. While there may be one more move towards 11,800 levels, the correction after that may take the Nifty to around 10,700, the lower end of the pattern,” says Sacchidanand Uttekar, Deputy Vice-President, Trade Bulls Securities.Buy portfolio insuranceA third option is to remain invested and participate in the ongoing rally and at the same time protect the downside with portfolio insurance. Just like insurance against loss due to untoward events such as death, disease, accident or natural calamity, investors can buy portfolio insurance to protect their wealth from possible market crashes. Only difference is that this will not be an insurance policy but a hedging strategy using futures and options (F&O) in the derivatives segment.Investors can hedge their portfolio by buying a put option. This can be for the broader market (index put) or for particular stocks. If you buy a put of the stocks you hold, you will make money if the stock continues to move up (because you hold the stock). But if the stock falls, part of the loss from the decline will be set off by gains from the put options.How much it will cost to hedge your portfolio 77819529Let us explain this with an example. Assume that you hold HDFC shares and want to protect its downside for a month with put options. You can buy put option with 1,850 strike price by paying a premium of Rs 60. Please note, this is for a protection against volatility and therefore, you will lose this entire premium if HDFC remains at the same level on the expiry date of 24 September. Treat it like any other general insurance policy (medical, accident, fire, etc) where you keep paying the premium every year even if the untoward event never happens.What happens if there is volatility? Now assume that HDFC jumps up or down by Rs 200 in a month. In the first case, your net gain will be restricted to Rs 140 because you have already lost Rs 60 in the form of put option premium. In the second case, you have a right to sell HDFC at Rs 1,850 and the price is at Rs 1,650, you will get Rs 200 as put option gains. This is the exact amount of loss you made on the counter. However, the premium of Rs 60 is already gone and therefore, your actual loss will be Rs 60.Premium reduction strategiesIf you hold a diversified portfolio through mutual funds or your stocks are not in the F&O segment, you can use put options of benchmark indices such as Sensex or Nifty. Indices are less volatile than individual stocks so the premium is lower. Also, there is greater investor interest in index options so there is high liquidity and more efficient pricing.Another way to reduce the premium is by taking ‘out of the money’ put options. Premiums of ‘out of the money’ options tends to be far lower. For example, the premium for HDFC put option with a Rs 1,750 strike price is only Rs 25 compared to Rs 60 for Rs 1,850 strike price. However, please note that buyers of Rs 1,750 put option don’t enjoy any protection till HDFC goes below Rs 1,750 levels. Same rule apply if you are using the index options as well. How much down one should go depends on the market situation. “Considering the current market situation, the correction may not be very big. So, only buy slightly out of the money put options and not deep out of the money put options,” says Sameet Chavan, Chief Analyst – Technicals & Derivatives, Angel Broking.F&O jargonPut option: It gives the buyer the right to sell a security (or an index) at a pre-determined price.Settlement date: The date on which the options will be settled.Strike price: The price at which the transaction will be executed on the settlement date.Premium: The price investors have to pay for buying the put option now.At the money put options: Puts with a strike price at the same level as the current stock price or index level. The premium depicts the real hedging cost.In the money put options: If the strike price is higher than the current market price. Here the premium will include the existing value in the put.Out of the money put options: If the strike price is below the current price. Since there is no value at this level, premium will be lower.

from Economic Times https://ift.tt/2ES1Cdu