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.
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