Hedging Equity Portfolios

Illustration: you hold shares worth Rs 31,85,000 that move roughly like Nifty. Nifty is at 24,500 and one lot is 65 units, so one lot controls 65 x 24,500 = Rs 15,92,500. Two lots therefore cover Rs 31,85,000. You buy two lots of a 24,300 put at a premium of Rs 150. Cost = 150 x 65 x 2 = Rs 19,500, which is about 0.6% of the portfolio.

Three outcomes at expiry. If the market falls 10%, your shares lose Rs 3,18,500, but the puts gain (24,300 - 22,050) x 130 = Rs 2,92,500, less the Rs 19,500 cost, for a net gain of Rs 2,73,000. The total loss is Rs 45,500 instead of Rs 3,18,500. If the market is flat, you lose only the Rs 19,500 premium. If the market rises 10%, you gain Rs 3,18,500 on shares less Rs 19,500, that is Rs 2,99,000.

This is the balance sheet of insurance. You give up a little in good times to avoid a lot in bad times. The hedge is imperfect: your shares are not the index, so they may fall more or less than Nifty. Before expiry, the put also loses time value, so the gain on a fall is less clean than the table shows. And a put that expires unused is money gone, every time you renew it.

Beta measures how strongly a share tends to move compared with an index. A beta of 1 means it usually moves with the index. A beta of 1.5 means that when the index moves 1%, the share has usually moved about 1.5%. It is calculated from past data and it changes, so treat it as a rough guide.

A first estimate of lots is: portfolio value x beta, divided by the contract value of one lot. With Rs 31,85,000, beta 1 and contract value Rs 15,92,500, the answer is exactly 2 lots. With beta 1.2 the answer is 38,22,000 / 15,92,500 = 2.4 lots. You cannot buy 0.4 of a lot, so you must choose 2 lots (slightly under-hedged) or 3 lots (over-hedged). A small portfolio may not fit even one lot: Rs 10,00,000 is only 0.63 of a lot.

This shows why lot sizes matter. Since SEBI raised the minimum contract value for new index contracts, one lot is large, and a small portfolio cannot be hedged closely with index options. Choices then are to hedge partly, to use a cheaper out-of-the-money put, to reduce the shares, or to accept the risk knowingly.

A put costs money. To pay for it, some investors also sell a call option above the market. This pair is called a collar. The premium received from the call reduces the cost of the put. It is like renting out the upper floor of your building to pay for the insurance on the whole building.

Illustration on one lot: buy a 24,300 put at Rs 150 and sell a 25,000 call at Rs 120. Net cost = (150 - 120) x 65 = Rs 1,950 per lot. Now your protection starts at 24,300, but your gain from the index stops at 25,000 (plus or minus the net cost). If the market rallies to 26,000, you do not share the gain above 25,000 on the hedged part, and the short call loses money that offsets your shares' gain.

So a collar changes a question, it does not remove risk. You swap unlimited upside for lower cost. If you sell a call and the market surges, that is a real opportunity cost. Also, keep in mind the tax difference: profit or loss on index options is taxed as business income, while gains on shares are capital gains, so a hedge can create a tax result that does not net off neatly. See the taxation modules and speak to a chartered accountant.