Hedge or Hedging is an investment strategy which aims to eliminate the risk involved in a portfolio. It is an investment which is inversely correlated to the underlying asset against which it has been transacted. Hedging involves cost and a basis risk. Basis risk is basically the risk that an underlying asset and the hedge against it will not be moving in the opposite directions as expected.

Hedging is usually done through derivatives such as options, futures and forward contracts. These are against assets like stocks, bonds currencies, indices, commodities or even interest rates. Derivatives tend to be effective hedge as the relation between these two is usually clearly defined.

In adverse market movements, hedging helps an investor to protect his/her trading positions and incurring a loss.

Take for example, a trader buys 100 shares of TCS at Rs. 2,000 per share, and after sometime he believes that the stock price may go down. In such cases, he can do either of the three actions:

1. He does nothing expecting the stock price to fluctuate and eventually increase.
2. He sells the stock and expects it to buy at a lower price
3. He can hedge his position.

In the first scenario where the trader doesn’t hedge his position, and the stock price goes down to Rs. 1,500, he will have to either wait for the stock price to rise again or sell it at a loss. A drop in a share price of 25% will take a increase of 33.33% to reach its value again, and this may take a lot of time unless a highly bullish market scenario comes into place.

In the second scenario if he sells the stock today at Rs. 2000 and the stock price increases to Rs. 2200, he will not be able to buy the stock at a lower price and will be having an opportunity loss of Rs. 200 per share. This scenario becomes very difficult as the price at which the trader wants to buy may or may not be reached by the stock. Further the transaction costs in buying and selling the stocks again may be higher

These are the reasons, why the trader should adopt the third scenario and go for a hedge as he will virtually protect his position in the market and will not be affected by the adverse movement in the prices.

The position of Rs. 2,00,000 in TCS which the trader has bought can be countered by taking a short position in the futures market. Let’s say the trader takes a position when Short Futures are at 2,010 for a lot size of 100.

Now let’s take three different price scenarios and see how the hedge would benefit the trader (ignored transaction costs for simplicity sake).

Thus, irrespective of the movement of prices, hedging will help the trader create a position where one neither gains nor loses money.

Remember, these hedges do involve costs, and can only be perfectly hedged if the size of the holding is similar to the lot size applicable in the derivatives market for that stock.