A strategy that uses offsetting positions to reduce the risk of adverse price movements in an existing investment.
Hedging is a risk-management technique where an investor takes an offsetting position in a related security to minimise potential losses from unfavourable price movements. Think of it as financial insurance - you pay a small cost upfront to protect against a much larger potential loss.
In practice, hedging often involves Derivative such as Options and futures. For example, a holder of 500 Reliance Industries shares purchased at ₹2,500 might buy a put option with a ₹2,400 strike price. If the stock falls to ₹2,200, the share position loses ₹1,50,000 but the put option gains most of that back, capping the downside at roughly ₹50,000 plus the premium paid.
On Indian exchanges, the most common hedging instruments are Nifty and Bank Nifty options traded on the NSE. Portfolio managers frequently use Nifty 50 futures to hedge broad-market risk. SEBI regulations require that all derivative positions be backed by adequate Margin, which means hedging is not free - the hedge leg has its own capital requirement.
The effectiveness of a hedge is measured by its hedge ratio - the proportion of the position that is offset. A perfect hedge (ratio of 1.0) eliminates all price risk but also eliminates upside. Partial hedges are more common; they reduce risk while retaining some profit potential.
A common hedging pitfall is over-hedging: protective positions priced so high that profits are entirely consumed by hedging costs. The objective is to bring risk within limits proportionate to portfolio size and stated risk tolerance, not to eliminate it.
India Context
SEBI mandates margin requirements for all derivative hedging positions. NSE offers weekly and monthly Nifty/Bank Nifty options commonly used for portfolio hedging.