Hedge break and hedging demystified: Everything you need to know

Investing comes with inherent risks that can lead to losses. With financial markets being inherently risky, hedging techniques help investors mitigate potential losses. 

This article explains the concept of hedging and the different hedging strategies used to offset exposure to market fluctuations. We cover key hedging terms like over-hedging, long hedging, and hedge break. Let’s begin!

What is hedging?

Hedging is a way to safeguard one’s financial assets against potential risks that might cause them to lose value. Although hedging may reduce the risk of loss, it does not eliminate it. Instead, profits from other investments will cover the losses whenever that happens.

Take the case of an investor who purchases a company’s shares in the hopes of a future price increase. On the other hand, the price falls, and the investor loses money. Hedging can be done through various financial instruments, such as futures, options, and spot.

If the investor employs an option to balance out the effect of such an undesirable event, it may reduce the loss. As with any investment, hedging involves considering the possibility of loss and making a conscious decision to protect your financial assets from unforeseen events. 

Similar to insurance, hedging tactics in finance aim to reduce risk. The hedging positions may compensate for any loss in an unexpected market decline.

Understanding over hedging

Taking an offset position that exceeds the initial hedged position is known as overhedging. It is a way to control risk. 

Investors can lower market risks and keep their investments safe from the adverse outcomes of a decline by setting up positions carefully. 

While overhedging is most often associated with the oil and fuel industries, it is also helpful in lowering the stakes in interest rate swaps, currency markets, and barrier options.

Understanding long hedging

A long hedge is buying a futures contract or another long position to safeguard yourself from rising prices. This strategy is often used by producers who rely on specific inputs yet are concerned about the potential impact of commodity price increases.

Companies that rely on inputs often enter futures contracts to lock in material prices at specific points during the year. This is why you can hear a long hedge called an input hedge, a buyers hedge, or a buying hedge. 

What is a hedge break?

Have you ever been in a situation where you made a trade and got a margin shortfall intimation? You may wonder whether there’s a correlation between exiting a transaction and a shortfall in your margin or an increase in your margin requirement. 

This is where a “hedge break” comes into the picture. It is known as a hedge break when you attempt to break a hedge by squaring off a position that has given you the hedge advantage on a different contract. 

Let’s consider the table to understand the concept better:

Based on 1 Sell Lot of NIFTY 50 19650 CE, it is evident that a ₹82,700 hedging advantage was granted on 1 Buy Lot of NIFTY 50 19650 CE. A hedge break happens when you sell off your remaining buying position, which removes the advantage of the hedge. 

Holding the position now requires a margin of ₹1,02,300, up from ₹19,600. You risk receiving an intimation for a margin shortfall if your account balance is below ₹82,700.

How to break a hedge?

• Based on the example above, suppose you want to do a bull call spread, which is a way to bet that NIFTY 50 will go up a little.
• You need ₹21,400 to do this and have ₹21,500, which means you can afford it.
• You bought a call option on NIFTY 50 with a strike price of 19600 and sold a call option on NIFTY 50 with a strike price of 19650. Both options have the same expiry date.
• Here, you also get a discount of ₹82,700 because the two options balance each other.
• Now, you decide to sell the option that you bought. This is called breaking the hedge.
• You no longer have a balance between the two options. This means you lose the discount of ₹82,700 and have to pay more margin to keep your position open.

How to exit in the event of a hedge break?

You may get out of the hedge’s negative side by leaving enough margin in your account before you make the hedge break transaction or by getting out of the higher-margin side of the hedge first.

Conclusion

Hedging enables investors to reduce potential losses through tried-and-tested strategies. Investors can use suitable hedging tools to balance their portfolios based on financial goals and risk appetite. 

Similarly, as an investor, it is equally necessary to know about hedge breaks to minimise margin shortfalls. 

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