How to Hedge a Portfolio with Options in India

Investors often find themselves in challenging market conditions, where volatility reigns supreme and unexpected events can affect portfolio values. The question arises: how do you protect a portfolio against these unforeseen risks? One effective method is through options, a versatile derivative instrument. While options are widely used in global markets, India's stock market also offers opportunities to hedge a portfolio using these instruments. This article explores how you can leverage options to mitigate risk, focusing on the Indian context.

What Are Options?

An option is a financial contract that gives the holder the right, but not the obligation, to buy or sell an asset at a predetermined price before or on a specific date. In India, options are traded on stock exchanges like the NSE (National Stock Exchange) and BSE (Bombay Stock Exchange). These contracts are tied to stocks, indices, and ETFs (Exchange-Traded Funds), allowing investors to hedge against both market-wide risks and specific stock movements.

Why Hedge with Options?

The Indian stock market, like any other, is prone to fluctuations due to political instability, interest rate changes, and global economic events. By using options, investors can lock in profits or minimize losses during turbulent times. There are two types of options to consider: call options and put options. Both offer unique ways to safeguard your portfolio, but knowing when and how to use them is critical.

Types of Options

1. Call Options: These give the holder the right to buy an underlying asset at a predetermined price, offering protection in bullish markets.
2. Put Options: These allow the holder to sell an asset at a set price, providing protection in bearish markets. Put options are particularly useful when hedging against a downward market trend, as they ensure that you can sell stocks at a favorable price.

Key Strategies for Hedging a Portfolio with Options in India

Protective Put

A protective put strategy involves buying a put option for a stock or index that you already own in your portfolio. This is akin to purchasing insurance: if the price of the stock falls, the value of your put option will rise, offsetting some or all of your losses. Here's how it works in India:

• Assume you own shares in Reliance Industries, a blue-chip stock in India. To hedge against a potential decline, you can buy a put option on Reliance Industries at a predetermined strike price.
• If the stock drops below this price, the put option allows you to sell at the strike price, limiting your loss.
• The cost of this strategy is the premium paid for the put option, which can be viewed as the insurance premium.

Covered Call

A covered call involves selling a call option for a stock you own. This strategy is particularly useful in a neutral or slightly bullish market. By selling the call, you collect a premium, which can help cushion the impact of any declines in the stock's value.

• For example, if you hold Tata Consultancy Services (TCS) shares and expect the stock to trade sideways or slightly upward, you could sell a call option at a higher strike price.
• If the stock doesn’t exceed this price, you keep both the premium and the stock, providing an additional layer of income to your portfolio.
• The risk lies in capping your upside: if the stock skyrockets, your gains will be limited to the strike price of the sold call option.

Collar Strategy

A collar is a hybrid strategy that combines buying a put option and selling a call option on the same stock. This limits both downside and upside, offering a balanced approach to risk management. Investors generally employ a collar when they want to protect their portfolio from volatility without paying too much for options premiums. In India, this is a popular method for safeguarding large positions in stocks like Infosys or ICICI Bank.

• To implement a collar, you buy a put option at a lower strike price while selling a call option at a higher strike price.
• The premium received from selling the call often offsets the cost of buying the put, making this a cost-effective strategy.
• If the stock price falls, your put option will mitigate losses, while gains are capped by the sold call option.

Hedging Against Market-wide Risks: Index Options

Hedging individual stocks is a good start, but how do you protect your portfolio from overall market declines? This is where index options come into play. In India, NIFTY and SENSEX are two popular indices, and options on these indices provide a way to hedge against broad market downturns.

• A commonly used strategy is buying put options on the NIFTY 50 index.
• For instance, if you're concerned about an economic downturn or a political crisis that could send the entire Indian stock market into a tailspin, purchasing a NIFTY put option can offset losses across your portfolio.
• This is particularly useful for portfolios that are heavily exposed to large-cap stocks, which tend to track the broader index.

Understanding Costs and Risks

While hedging through options can significantly reduce risk, it also comes with costs and limitations. The primary cost is the premium paid to purchase options. In the case of put options, if the market doesn’t decline, you lose the premium paid. Similarly, selling call options caps your potential profits, which might not always be desirable if the market surges.

• Time decay: Options are time-sensitive. As the expiration date approaches, the value of an option can erode, particularly if the underlying stock’s price hasn’t moved significantly.
• Volatility: Implied volatility affects option premiums. When markets are volatile, premiums tend to rise, making it more expensive to hedge your portfolio.

Real-World Example: Hedging with NIFTY Options

Let’s assume you have a portfolio of large-cap Indian stocks, including Tata Motors, HDFC Bank, and Bharti Airtel. You’re concerned about an upcoming economic event that might negatively impact the Indian market. In this case, you could:

1. Buy a NIFTY 50 put option with a strike price slightly below the current index level.
2. If the market drops as anticipated, the put option gains value, offsetting some of the losses in your stocks.
3. The downside is that if the market doesn’t fall, the premium you paid for the option becomes a sunk cost.

Tax Implications in India

Investors should also consider the tax implications of trading options in India. Gains from options trading are considered short-term capital gains and are taxed accordingly. However, when used for hedging, the focus should be on protecting your capital rather than generating returns from the options themselves.

Conclusion

Hedging a portfolio with options in India provides a flexible way to protect your investments from both market-wide and stock-specific risks. Whether you choose a simple protective put, a covered call, or a more complex strategy like a collar, options can help safeguard your portfolio during periods of uncertainty. It’s essential to understand the costs, risks, and potential rewards before diving into options trading. With the right approach, options can be a powerful tool in managing portfolio risk.