Aim to make loss on your hedge to create wealth in longrun

Strange, very strange..How come aiming to make loss can make you wealthy? Well, consider the following examples :

1.  You buy health insurance for your family for say, Rs.50,000. The validity of the insurance contract so bought is say, one year. During this one year, the insurance company promises you to reimburse / pay directly to the hospital on your behalf, the entire cost of treatment in the event of hospitalization of any of the family member. The insurance contract broadly works on these lines with small riders here & there. When you buy health insurance, you wish that such a situation may not arise when you may have to use the benefit of such insurance & if at all any such situation arises where you have to pull out the health insurance card, your expenses (losses) get limited & the burden to bear the expenses shifts from you to the insurance company.  In other words, you preferably intend that the expense incurred on buying the health insurance goes waste / becomes a sunk cost / becomes a loss instead of encountering a situation where you have to use it. However, to secure yourself from the burden of expenses, in case such a situation arises where you have to use such insurance, you buy health insurance – but this is not your preferable intention, ie, you do not preferably want to get into such a situation at the first instance where you have to use the benefits of such health insurance or simply do not start leading a more riskier life just because you have bought the health insurance.

2.    Similar is the situation when you buy insurance for your car. Ignoring the fact that law requires it, you primarily buy your car insurance to get secured from the burden of expense that may arise in case of an accident. By paying a small premium, you shift such burden from yourself to the insurance company. Here again, your first preference is that you may not get into such a situation where you may have to use the benefits of the insurance so bought & you prefer that the cost of buying such insurance should go waste rather that encountering such a situation where you have to use the benefits of such insurance, ie, you do not intentionally start indulging in rash / risky driving just because you have bought car insurance.       

What happens if out of greed or ignorance, we do not buy insurance? We get heavily penalized under the laws of the country (in case of car insurance) and / or have to bear the heavy burden of expenses, if any unpleasant situation arises.

Exactly similar is the situation in the stock market. To understand things further, lets understand the concept of hedge first.

According to Wikipedia, a hedge is an investment position intended to offset potential losses or gains that maybe incurred by a companion investment. A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded-funds, insurance, forward contracts, swaps, options, gambles, many types of over-the-counter and derivative products and future contracts.

In simple words, a hedge is a type of an insurance contract which stands opposite to your initial investment position. Eg, if the share of company ‘X’ moves with the index (directly proportionate) & the share of company ‘Y’ moves against the index (inversely proportionate) and your view about the index is bullish, you may opt to buy 100 shares of company ‘X’ & alongwith that you may buy 50 shares of company ‘Y’ as a ‘hedge’. This hedge actually comes into play to rescue you if your view about the index turns wrong & the index turns bearish. Once that happens, the 100 shares of company ‘X’ would start giving you losses & the 50 shares of company ‘Y’ bought as hedge would start generating profits, reducing the overall losses. Had you not bought the hedge, i.e., shares of company ‘Y’, your only & overall loss from shares of company ‘X’ would have been higher if the index turned bearish against your expectations of going bullish.

As I write this article on 30.04.19, the share price of ‘Yes Bank’ (a Nify 50 stock – these stocks are usually assumed to be the frontliners of their respective sectors) is down to Rs.168, by over 29% from its previous day close of Rs.237 – inspiring me to write this article & impress upon the importance of ‘Hedging’ in stock market, which is usually undermined.

Hedging in stock market comes in various forms such as futures, options, spreads etc. Then there are simple hedging techniques & advanced hedging techniques. Going further, there are cheap but not-so-effective hedges, costly but very-effective hedges, event specific hedges, short term hedges (like travel insurance bought only for five days), medium term hedges & long term hedges. These are like shields of different shapes, sizes and thickness which protect you from losses in case the index / share price starts moving against your expectation / position. The selection of particular hedge depends on the prevailing market condition & its proven effectiveness under that particular market condition. Eg, if you are slightly thirsty & your home is nearby, you would prefer buying a small water bottle but if you are travelling with your family in summers & your home is 100 kms away with no shop en-route, you would prefer carrying along a mini-refrigerator full of water bottles / other drinks in the boot of your car. Similarly, depending upon the market conditions – whether it is sideways, slightly bullish, moderately bullish, very bullish, slightly bearish, moderately bearish or very bearish over a period of short-term, medium-term or long-term, you choose & use different types of hedges effective in the respective market conditions. Choosing the right hedging technique in line with the prevailing market condition requires in-depth knowledge about the working of the different hedging techniques under various market conditions. Expertise in choosing the correct hedging technique in line with the market condition is achieved gradually – initially by paper-trading & subsequently by applying the techniques successfully in the live market.

It must be understood that hedging is not a substitute for safety in itself, but is a means of remaining safe. Its similar to your health insurance or car insurance. It does not give you liberty to take risky trades but saves you to a certain extent if the situation turns against you unexpectedly. As in case of health insurance or car insurance, if a situation arises where you have to use those insurance contracts to indemnify yourself, it would obviously imply that you have got into some problem. But if you are on a business trip & travelling by road and your family comes to know that you have not used either your car insurance or your health insurance, they can safely assume that you are in a perfect shape. They would want that money spent on buying car insurance & health insurance goes waste – because its only when the money spent on buying insurance goes waste, your family & your car would be shining bright..so its something like either your insurance goes waste or you get into some problem & obviously you choose the former.

In the stock market also, you buy the hedge as insurance to your original investment action. Its only when you take non-risky trades & opt to play safe, will your hedge (insurance) will go waste & your original investment (equivalent to you & your family / your car in the example at para above) will reap fruits. Hedge is bought to counter an adverse situation arising unexpectedly & you should not make a mistake to take the liberty to un-follow the SOP’s of investing in the stock market just because you have bought the hedge. Remember, the hedge is only to limit your losses & once the hedge is made to play, the losses would arise for sure, although limited. Therefore, your first preference / aim should be not to get into such a situation where the hedge has to bail you out & you must invest in a manner whereby the money spent on hedge goes waste, ie, you make a loss on your hedge, because its only then that your original investment shall remain safe & swell.

Importance of Hedging :

None, except two people, in the history of stock markets across the world have always been able to time the market (buy at the lowest price & sell at the highest price). Any guesses about the names of these two? Its none other than God & the liar! In the stock market its impossible to buy at the lowest point & sell at the highest point – this implies that the share price can (& in 90% of the cases, does) fall further after you buy the specific share & can rise further after you sell it, even if bought / sold in tranches at different price levels. You usually never know the exact point till which the share price / index can fall or rise (all the indicators, charts, candlestick patterns, moving averages etc. give an idea / probability of share price / index reaching the particular level of support or resistance on the basis of past behavior of the share price / index upon reaching near those levels, but do not guarantee that such levels of support or resistance would be respected by the share price / index). The movement of share price / index are either random or at times / to a certain extent in the hands of big players, the information about which is usually not in the public domain. This inherent nature of the shares / index calls for hedging on a serious note & hedging your trades at all the times is the only way to make money & lots of it in the stock market in longrun.   

However, the concept of hedging is not taken too seriously in India especially by the retail investors. This is either due to lack of correct knowledge, ie, ignorance about hedging and the manner in which it is to be used or simply due to greed – since hedging comes with a price, though a small price. The following example would clarify the point :

Mr. A buys 100 shares of Yes Bank on 26.04.19 at Rs.237 a piece, investing a total of Rs.23,700 in the counter. On 30.04.19, he wakes up to see that the share is trading at Rs.168 a piece (portfolio value Rs.16,800), down by over 29%. At this juncture, he finds that he cannot do much about the whole situation – he can either sit with the stock for unknown, but fairly long period of time & wait for the share price to rise or can sell the shares at a loss. He realizes that he left no stone unturned in doing the technical / fundamental analysis of the share. He waited for the RBI’s clean chit report about the bank before putting in his money, verified the holding pattern in the counter (approximately 40% FII holding & 20% promoter holding signaling strength in the counter), made sure he bought the shares of Yes Bank only when it had broken out above its 200 DEMA and also verified its 52 week high low (which were 404 & 147 respectively), before investing his hard earned money in that counter. He did his due diligence in the light of information available in public domain. However, what he did not do was to buy the hedge (insurance) and here came the black swan day when his capital was wiped out by over 29% within just two trading sessions. Had he bought the hedge (which he did not due to ignorance or greed) and which was available at a fraction of price of his total investment or which he could have acquired almost for free using the advanced hedging strategies (yes, this can very much be done!), he would have been far better positioned on 30.04.19 with loss of not more than 2-3% of his investment (instead of 29%!). That’s the benefit of hedging.

The irony is that the big players – the FII’s & the DII’s who rarely make losses in the stock market (only due to hedging), consider investing without hedging as a crime & the retail investors who have a very small risk appetite usually ignore it resulting in their account getting blown up, bearing most of the brunt when the situation in the market goes against them suddenly & unexpectedly. The aim of capital conservation must always prevail over the aim of making profits in the stock market.

Hedging is the most important action which must be taken AT THE SAME TIME when one punches in the initial order to invest / trade. A naked (without hedging) investing / trading action is similar to jaywalking in a terrorist infected area without any precautions – a stray bullet is sufficient to give a permanent loss.  One must give due importance to hedging & must equip oneself with the required skillset BEFORE venturing into the stock market – it doesn’t work vice versa as one never knows which day would be the D-Day.

Learning about the Stock Markets - The Right Way - From the Experts

Stock market reminds me about the story of six blind men who once went to the jungle & banged into something huge. All of the six blind men could not figure out what exactly they have had an encounter with. A passerby told them that it was an elephant & soon they started to decipher the physical attributes of an elephant with whatsoever little knowledge they gained by touching / feeling it. The poor elephant was kind enough to remain stagnant & allowed them to explore itself while enjoying the way the group of six made a head or tail out of his huge physical layout. The conclusions of the six men were as follows :

“Hey, the elephant is a pillar,” said the first man who touched his leg.

“Oh, no! it is like a rope,” said the second man who touched the tail.

“Oh, no! it is like a thick branch of a tree,” said the third man who touched the trunk of the elephant.

“It is like a big hand fan” said the fourth man who touched the ear of the elephant.

“It is like a huge wall,” said the fifth man who touched the belly of the elephant.

“It is like a solid pipe,” Said the sixth man who touched the tusk of the elephant.

They began to argue about the elephant and everyone among them insisted that he was right. It looked like they were getting agitated. A wise man was passing by and he saw this. He stopped and asked them, “What is the matter?” They said, “We cannot agree to what the elephant is like.” Each one of them told what he thought the elephant was like. The wise man calmly explained to them, “All of you are right. The reason every one of you is telling it differently because each one of you touched a different part of the elephant. So, actually the elephant has all those features what you all said.” “Oh!” everyone said. There was no more fight. They felt happy that they were all right. The moral of the story is that there may be some truth to what someone says. Sometimes we can see that truth and sometimes not because they may have different perspective which we may not agree with. So, rather than arguing like the blind men, we should say, “Maybe you have your reasons.”

Stock market is also like a big huge elephant. A lot of people – investors, traders, speculators, trainees, casual traders / speculators visit the stock market on daily basis & decipher it in their own way based on the experiences they had with the stock market or the manner in which the stock market behaved during the period they were active in the stock market. Everybody is 100% correct within the limited scope of their observation. Stock market is ever changing like flowing water. As you cannot touch the flowing water twice, similarly, you cannot have exactly the same situation is the stock market at micro / macro level again. One has to remain ever-flexible to decipher the ever-changing stock market – this is an additional requirement to understand stock market vis-à-vis understanding the elephant which remained same at all the timesJJ

For example, a person who visited the stock market for the first time on say, 20^th of September, 2018 when the stock market was stagnant shall have a different story to tell than a person who visited the stock market on 21^st of September 2018 when the stock market suddenly turned ultra-volatile and made sudden huge moves. A person who is a seasoned trader & investor for last 20 years would decipher the events of 20^th & 21^st September 2018 in a totally different manner. The probable comments of the three would be :

1.      The gentleman who visited the stock market for the first time on 20.09.18 – “Stock market is a good & easy way to make money. Anyone can step in, buy some good shares & sell them at higher price on subsequent date & make profit. The stock market works as expected, is predictable & its movements don’t deviate from the laid down path. This is how the stock market generally behaves.”

2.    One who visited the stock market for the first time on 21.09.18 – “No one can make money from stock market. It’s a trap & you are bound to lose money. The movements in the stock market are totally unexpected & non-predictable. There is no path which the stock market follows. This is how the stock market generally behaves.”

3.   The version of seasoned trader & investor who was present in the stock market on 20.09.18 & 21.09.18 and has been working in the stock market since 1998 – “Since the stock market was volatile for last couple of days & was also in an overbought zone, it was expected to correct or take sudden sharp turns. It was clearly visible on a couple of indicators. This generally happens when the VIX is high & it was not an unexpected event. This is how the stock market generally behaves.”

Its interesting to note that all three of them concluded the same thing – “This is how the stock market generally behaves”, but had different reasons for their respective conclusions. It’s their respective exposure, experience & education about the stock market which lead to their differential reasoning about the behavior of the same stock market on the same set of days.

Therefore, its very important to possess the correct set of skills, complete theoretical knowledge about the stock market & the manner in which it behaves in short-term, mid-term & long-term before venturing into it. Although, practical knowledge can be gained only after gathering courage to jump off the diving board (obviously towards the poolside!), but certainly the fruits are worth an effort & time spent in learning.

Welcome to the enormous world of leaning the stock markets, the right way, directly from the Experts.