Hedger

What are the different participants in derivatives market?

There are three main types of participants in the derivatives market whose individual actions leads to market formation and rise or fall in the price of individual securities or the overall market.

• Hedger
• Speculator
• Arbitrageur

First, let us start with ‘Hedger’. We will discuss the other two 'Speculator' and 'Arbitrageur' in the subsequent sections. 

Hedging means making an investment or taking a position to reduce the risk of adverse price movements in an asset. It enables an individual to reduce the risk arising out of future price uncertainty.

In our introductory section, the example of ITC and the farmer which we discussed, both the counterparties, by the virtue of entering into the futures contract, were acting as hedgers.

Hedging Through Futures

Hedging in equity market or any other market could be possible by using various types of derivatives products. Hedging via use of futures contract is one of the simplest forms of hedging possible and it could be executed under two scenarios:

• Long Security or underlying asset, Sell Futures
• Short Security or underlying asset, Long Futures

Long Security or underlying asset, Sell Futures

A trader buys a security at ₹800, and he might be worried about the share price going down, so in order to hedge the position, he or she can short the futures of that particular security.

Assume that the spot price of the security he holds is ₹800 and the 2 months' future contract he was holding cost him ₹804. For this he pays an initial margin. Now if the price of the security falls any further, he will suffer losses on the security he holds. However, the losses he suffers on the security will be offset by the profits he makes on his short futures position. 

Take for instance that the price of his security falls to ₹720. The fall in the price of the security will result in a fall in the price of futures and the same will now trade at a price lower than the price at which he entered into a short futures position.

Hence his short futures position will start making profits. The loss of  ₹80 incurred on the security he holds, will be made up by the profits made on his short futures position. However, in case the security price goes up instead of falling, then the profit he makes from his position in the underlying security is also wiped off from the loss he makes from his futures position.

Thus, it is not necessary that hedging always benefits an individual. The best that can be achieved using hedging is the removal of unwanted exposure, i.e. unnecessary risk and all that can come out of hedging is reduced risk.

Hedging lock in the price of the security at which the hedge is entered and even if price rises or falls, the investor will realize the same value from the underlying asset.

Short Security or underlying asset, Long Futures

An investor sells a security say Reliance industries at ₹1000 and he might always be worried about the share price going up, so in order to hedge himself he can go long in futures.

Assume that the spot price of the security he holds is ₹1000 and the 2 months' future contract he was holding cost him ₹1004. For this he pays an initial margin. Now if the price of the security goes up further, he will suffer losses on the security he holds. However, the losses he suffers on the security will be offset by the profits he makes on his long futures position.

Take for instance that the price of his security rose to ₹1050. The rise in the price of the security will result in a rise in the price of futures also. Futures will now trade at a price higher than the price at which he entered into a long futures position. Hence his long futures position will start making profits. The loss of  ₹50 per share incurred on the security he holds will be made up by the profits made on his long futures position. 

Thus, what he has done is lock in the price of the shares in his portfolio at ₹1000 and even if the price goes up or comes down, he would still realize the same ₹1000 from selling the shares and coming out of the futures position.