Worried about a stock market crash due to war, inflation, recession? Hedge your portfolio right | The Financial Express

Worried about a stock market crash due to war, inflation, recession? Hedge your portfolio right

There are a few methods which can help you hedge your portfolio right if you are invested in the equity market.

Worried about a stock market crash due to war, inflation, recession? Hedge your portfolio right
Long Put Option is a plain vanilla approach that is often used by market participants to hedge their portfolio.

Equity markets have an inherent nature of going up but they don’t do that in a linear fashion, do they? From time to time, there will be healthy corrections, bear markets and occasional crashes. We all learnt that from the Covid crash that happened in March 2020, benchmark indices in equity markets more than doubled from those crash lows in 2020 in a little over a year’s time-span.

Comes the fear again due to war, inflation, rate hikes, recession, etc and deja vu, talks of a market crash are all over again. In this article, I will talk about a few methods by which you can hedge your portfolio if you are invested in the equity market that would give you some protection on the downside if that crash were to happen. Let’s begin.

1. Long Put Options – This is a plain vanilla approach that is often used by market participants to hedge their portfolio. In simple terms, if the market goes up, the put options would go down and vice versa, assuming other factors like volatility, time to expiration of those put option contracts were to be kept constant. For benchmark indices like Nifty 50 and Bank Nifty, the option contracts are available for weekly and monthly (upto 3 months from now) and yearly contracts (December expiry) as well.

Based on the exposure one has in the market and their view, they can accordingly buy the put options. Assuming a 20L portfolio, one can buy 4 lots of 16000 strike Dec put options worth 40k. If there was a 10% correction in indices, this method would give them a cushion of about 4-5% protection depending on when (and if) that correction happens. For active investors, this is an approach that can be done in weekly/monthly options too.

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2. Short Risk Reversal – This is similar to the previous method but the cost of buying put options is reduced to a certain by selling call options. So, assuming the same 20L portfolio and one buys 4 lots of 16000 strike put options worth 40k, they can simultaneously sell 20000 call options to reduce the cost of buying put options. Note that this only brings the cost of buying puts down to some extent and not fully. One downside to this method is that if the markets were to go up substantially higher from these levels ignoring all the pertaining risk, this strategy can quickly turn into losses. If you are not well versed with options pricing and behavior, this is not a recommended approach.

3. Put Backspreads – This is a bearish strategy that involves selling put options near to the index spot value (also known as ATM option or slight OTM option) and buying more OTM options. This can be deployed currently to hedge their portfolio. This method requires to select an expiry that is at least 40-45 days to go. Assuming the same 20L portfolio again, one can sell 2 lots of 17500 Oct month end put options and buy 6 lots of 17000 put options again from the Oct expiry. There won’t be much loss if the market stays here or goes up.

And in case there is a 5-6% correction, it would give a cushion of again about 3-4% protection. One important thing to note here is you should not keep this trade open when there is less than 20 days to expiry. If the fear and uncertainty is still around, the position can be closed and a similar position can be initiated in next month’s options.

Please note that this is not off the shelf calculation for every portfolio. It works if the portfolio is correlated to the benchmark index Nifty 50. Readers can accordingly adjust the position size if they have high beta counters in their portfolio.

(By Ashish Gupta, Volatility Trader and Derivatives Expert)

Disclaimer: This is the author’s personal opinion. Readers are advised to consult their financial planner before making any investment.

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