What Happens To The Hedged Position?
The index is the best way that you can minimize the unsystematic risks. How to hedge a stock portfolio? To understand it you need to know about the Beta.
What is a beta?
Beta is the Greek symbol which is an important concept in the financial world. There are a number of uses of beta in the market. The beta finds application in hedging the portfolio of stocks. The beta is basically the stock sensitivity with respect to what changes happen in the market. So if the market moves up by 2% then how much will the stock move? How risky is the stock as compared to the index and how risky is the stock as compared to some other stock? All this is affected by beta.
The beta of stock can take the value that is either greater or lower than zero. The beta of the index is more than 1.
How is this done?
Suppose you have some money invested across many stocks. You would first have to calculate the beta of your portfolio. This is calculated as the sum of the weighted beta of each stock in your portfolio. You multiply the individual beta of the stock with the respective weight if the stock in your portfolio, the weight of the stock is calculated when you divide the sum invested in each of the stock by the total value of your portfolio.
Suppose the beta of your portfolio is 1.2. This means that if the index goes up by 1% your portfolio goes up by 1.2%. The same applies to the downward move too. If the index goes down by 1% then your portfolio goes down by 1.2%.
The hedge value is calculated as the beta multiplied by the amount that you have invested. Learn more about it here. This is a portfolio of stock that you are long on. To hedge, you will have to take counter position in the index futures market. So to hedge your portfolio in the stock market you need to short futures of the index for the hedged value which is the value if the amount invested multiplied by the beta value.
The hedge value divided by the contract value is the number of lots that you should invest into.
There would be many times when you would not be able to hedge the portfolio perfectly. This is because futures contracts come in predetermined lot size which cannot be changed.