Welcome back to our series on portfolio hedging for Indian HNIs. In our previous post, we discussed the basics of portfolio hedging and introduced strategies like using derivatives and asset allocation to manage risk effectively. In this post, we’ll delve into more advanced hedging techniques and how they can be applied in portfolio management.
Advanced Hedging Techniques
- Tail Risk Hedging: Tail risk hedging focuses on protecting your portfolio against extreme market events or “black swan” events that can result in significant losses. One common approach is to use options strategies such as buying out-of-the-money put options or constructing option spreads with asymmetric payoffs. These strategies provide insurance against sharp market declines while allowing you to participate in market upside.
- Volatility Hedging: Volatility hedging aims to mitigate the impact of market volatility on your portfolio. One popular method is to use volatility derivatives such as VIX futures or options. By taking positions in these instruments, you can profit from increases in market volatility, which often coincide with market downturns. Additionally, strategies like delta hedging can help offset the risk of changes in option prices due to volatility fluctuations.
- Correlation Hedging: Correlation hedging involves diversifying your portfolio across assets with low correlation to each other. By spreading your investments across uncorrelated or negatively correlated assets, you can reduce the overall risk of your portfolio. For example, combining equities with fixed income securities or alternative investments like commodities or real estate can help diversify your portfolio and reduce sensitivity to market movements.
Example Strategy: Tail Risk Hedging with Put Options
Let’s expand on our previous example of using put options to hedge your equity portfolio. Instead of simply purchasing put options with a fixed strike price, you can employ a more sophisticated strategy known as a “put spread.”
Suppose you’re concerned about a potential market crash, but you also want to limit the cost of hedging. You can achieve this by selling out-of-the-money put options with a lower strike price and using the proceeds to partially finance the purchase of at-the-money or in-the-money put options with a higher strike price.
For instance, if the current value of the Nifty 50 index is 22,000, you can sell put options with a strike price of 20,000 and use the premium received to purchase put options with a strike price of 19,500. This put spread strategy allows you to hedge against extreme downside risk while reducing the net cost of the hedge.
If the market experiences a moderate decline, the sold put options will expire worthless, but the purchased put options will provide protection against further losses. On the other hand, if the market crashes below 19,500, the put options will increase in value, offsetting the losses in your equity portfolio.
In conclusion, advanced hedging techniques offer sophisticated ways to manage risk and enhance portfolio resilience. By incorporating these strategies into your portfolio management approach, you can navigate volatile market conditions with confidence and safeguard your wealth over the long term.
Stay tuned for our next post, where we’ll discuss practical tips for implementing and monitoring your portfolio hedging strategies effectively.
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