Stock market trading relies on a key rule: risk management. When you invest in stocks, you want to ensure that they can sustain market fluctuations without facing losses. This is where hedging comes into the picture.

As a trader, you must have come across the term “hedging” numerous times in the stock market as a strategy to offset losses. In this article, we will learn how future options can be used for hedging.

• Hedging is a risk management strategy used by traders to mitigate potential losses by creating an opposite position in the market.
• Futures trading allows the trader to trade in the existing stocks at a pre-determined price, thus hedging against market fluctuations.
• Options trading is done to hedge against volatile stocks by holding a position with the flexibility to choose whether to proceed with a trade or not. 

Let’s begin by understanding what is hedging and its importance for traders. Hedging is a trading strategy in which traders take an opposite position in the stock market to reduce the loss potential of highly volatile stocks in their investment portfolio.

This is based on the principle that the price of certain stocks tends to move in the opposite direction of other stocks. By holding positions of the opposite stocks, traders try to control the price movement of their existing stocks.

Futures trading is done by entering into contracts between a buyer and seller to purchase and sell a certain number of stocks in the future at a pre-determined price. Let’s see how you can use the futures market for hedging.

Let’s say you buy 300 stocks worth Rs. 2350 in a company, amounting to a total investment of Rs. 7,05,000. Now, due to market conditions, you are predicting a fall in the value of these stocks.

To mitigate the loss, you hedge with a short position to maintain a neutral position in the market. Now, even if the value falls, you will still hold the same position from the futures market or contract. 

Another reliable hedging method used by traders is by entering into options trading. Options trading is where traders get ownership rights over shares but are not obliged to trade those shares. Let’s take an example to understand how options trading can be used for hedging:

Say you buy stocks of a company worth Rs. 100/piece. Now, three scenarios can arise if you enter into options trading over these stocks with a premium of Rs. 5:

1. The price moves to Rs. 110 per stock

You can end the contract and make profit from Rs. 10/stock. In this, you pay Rs. 5 premium and Rs. 5 is your profit.

2. The price declines to Rs. 80 per stock

In the cash market, this reflects a loss of Rs. 20. However, from the derivatives market, you make a profit of Rs. 15 after paying the Rs. 5 premium.

3. The price stays the same

If the price remains the same, i.e., Rs. 100/stock, then you don’t trade at all and suffer a loss of only Rs. 5 paid as a premium. 

Futures and options trading is a key strategy used by traders looking to hedge against losses. The simple principle of futures and options for trading is sealing the price of an underlying asset to avoid losses in future. As much as these strategies are reliable, remember that you need to have an in-depth understanding of the market movements.