Types of Hedging: Strategies for Indian Investors

Highlights:

• Understand the meaning of hedging and how it protects portfolios using derivatives
• Learn types of hedging instruments traded on NSE: futures, options, commodities
• Discover hedging strategies fund managers use to reduce market losses
• Recognise risks: Nearly 91% of individual traders incurred net losses in equity F&O in FY25, with aggregate losses of about ₹1.05 lakh crore (SEBI study)

Introduction

Hedging sounds defensive, but it’s strategic. When markets turn volatile, knowing how to offset risk separates conviction from panic. Indian markets offer several derivatives to hedge positions, but each type of hedging comes with its own mechanics and complexity. Here’s what active traders need to know.

What is Hedging in the stock market?

Hedging is a risk management strategy in which investors use financial instruments to offset potential losses from adverse price movements. SEBI has long viewed derivatives primarily as tools for hedging and portfolio balancing (rather than pure speculation), especially for mutual funds, insurers, and bona fide hedgers. Think of it as insurance for your portfolio: you pay a cost (premium, margin, or opportunity cost) to protect against downside

The goal isn’t eliminating risk entirely but reducing it to acceptable levels. If you hold diversified equity, hedging with index futures protects against broad market declines without selling stocks.

Types of Hedging Instruments in India

Indian exchanges offer these main hedging instruments:

Futures contracts: Standardised agreements to buy or sell an asset (index, stock, or commodity) at a predetermined price on a future date. Equity index and stock futures trade on NSE and BSE; commodity futures mainly on MCX (with some on NSE). They require margin deposits and are marked-to-market daily.

Options contracts: They give the buyer the right (but not the obligation) to buy or sell at a predetermined strike price by a set expiry. Equity options are highly liquid on NSE (especially Nifty and Bank Nifty). Losses for the buyer are limited to the premium paid.

Commodity derivatives: Used mainly by producers, consumers, and traders to hedge physical exposure (gold, silver, crude, agri commodities, etc.). NSE and MCX have specific hedge policies that allow bona fide hedgers additional non-transferable position limits beyond normal client limits.

Currency derivatives and OTC instruments: Exchange-traded currency futures/options (USD-INR, etc.) on NSE/BSE, plus OTC forwards and swaps. RBI rules generally require underlying exposure for genuine hedging of forex risk.

Common Hedging Strategies Using Derivatives

Fund managers and institutional investors employ several hedging techniques:

Index futures hedging: Holding a Nifty 50 portfolio? Selling Nifty futures offsets broad market declines. Stock losses get balanced by short futures profits.

Protective put strategy: Buy put options on stocks or indices you own. If prices fall, put gains offset stock losses. Cost: option premium paid upfront.

Collar strategy: Combine protective puts with covered calls. Limits both losses and gains, useful for defined risk parameters. Understanding behavioural biases helps avoid emotional hedging decisions.

According to SEBI guidelines, fund managers may sell index futures or buy index put options specifically to reduce losses from market downturns.

How Hedging Works in Indian Markets

NSE maintains a detailed Commodity Derivatives Hedge Policy under which bona fide hedgers can obtain additional non-transferable hedge limits beyond normal position limits. Equity derivatives are subject to SEBI’s position limits, peak-margin rules, and (for institutions) strict hedging-purpose requirements.

Practical example: You hold ₹10 lakh in Nifty stocks. Expecting short-term volatility, you sell one Nifty futures contract (current lot size 65; assume futures around 24,600). Notional value ≈ ₹16 lakh. If Nifty drops 5%, your equity portfolio loses roughly ₹50,000. The short futures position gains approximately ₹80,000 (65 × 5% of 24,600), more than offsetting the equity decline (exact offset depends on beta and exact prices).

SEBI requires daily margin monitoring, mark-to-market settlement, and disclosures to ensure positions remain legitimate hedges rather than speculative bets. Recent measures have also tightened short-dated options and introduced delta-based open-interest monitoring.

Risks and Costs of Hedging

Hedging is neither free nor foolproof. Costs include:

• Option premiums
• Futures margin (SPAN + exposure) and opportunity cost of capital
• Brokerage, STT, GST, and stamp duty

More importantly, hedging caps upside. If markets rally strongly, protective positions become losses. Basis risk (imperfect correlation between hedge and underlying), mismatched expiries, and over-hedging can increase rather than reduce risk.

Complexity is the biggest danger for retail participants. SEBI’s FY25 study of ~96 lakh unique individual traders (via the top 13 brokers) found that nearly 91% incurred net losses in the equity derivatives segment, with aggregate net losses of about ₹1.05 lakh crore (up 41% year-on-year) and an average loss of roughly ₹1.1 lakh per losing trader. Transaction costs further erode outcomes. Most losses stem from speculative short-dated options rather than genuine hedging.

Know Before You Hedge

Types of hedging strategies offer powerful risk management when executed with precision. Futures, options, and commodity derivatives each serve different purposes across Indian markets. The real question isn’t whether to hedge, but whether your knowledge matches the instrument’s complexity. For most DIY investors, understanding these mechanics precedes using them.

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