In this post we are going to discuss about hedging and arbitrage. So let's start.
What is hedging?
In a simpler term, hedging means insurance. Now if we
understand what is insurance and why we take insurance, then we will clearly
understand the meaning of hedging and its purpose.
So what is insurance? It is an arrangement by which a
company undertakes to provide a guarantee of compensation for specified loss in
return for payment of a specified premium. A trader has hedged his
portfolio means he has protected his portfolio by taking position in stock
market. Let’s understand it by an example.
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I have a biased interest in TATA group of companies and from
all the companies of that group I preferred TATA Motors. I bought the shares of
TATA Motors because I think this share is an underdog. It can perform well in
future. But at the same time, as market doesn’t go as per my conviction, I have
a fear that TATA Motor’s share may go down. That’s why I sold the shares of
Ashok Leyland, a competitor of TATA motors, in future market. Now there will be
two cases.
Case-1: I was proved right.
TATA Motor’s share goes up and I earned profit. But at the
same time I face loss in Ashok Leyland because I have short position in that
share. If I considered the net position
then I will find a net profit from my trades.
Case- 2 I was proved wrong.
If something contrary happens against my analysis then TATA
Motors will go down and I will bear a loss. But thanks to Ashok Leyland! I will
earn profit from there to minimize my loss. Hence I will bear a loss which is small
in compared to the gross loss I was having in TATA Motor’s share.
What we learned from this example? No matter I was right or
wrong, in both the cases I gained something. In first case I gained profit
whereas in second case I minimized my loss.
Not having loss is
also a kind of gain.
In stock market big players play with big money and they
have responsibilities. So they can’t just play randomly. They always take hedge
positions to reduce their risk. The traders who take long position make their hedge
by taking short position in other shares. Traders, who initially take short
positions, make their hedge by taking long position in other shares. The fund
managers always prepared for the downside risk of markets by taking a
calculated hedge positions.
So it is a very important tool in capital market.
What is arbitrage?
Arbitrage is basically having profit by buying a security in
one market and simultaneously selling it in other market at a higher price. This
is the process of identifying and trading the temporary differences in price of
the securities in different markets.
For example I observed a seller is selling shoes in a shop.
He is quoting ₹400 per pair. I moved to a shop which
is in other area of the city. Interestingly I saw that the same shoes are
quoting at ₹420. I asked the seller his buying price. He said it costs ₹410
to them because they buy those shoes from other cities. Now I get a chance to
earn profit here. I ran to the first shop and buy shoes ₹400 and immediately
sold those shoes to the second seller ₹410. My travelling cost was ₹20.
I have sold 20 pairs of shoes. Now can you tell me the profit I earned?
Sales = 20*410= ₹8200
Purchase = 20*400 = ₹8000
Travelling cost = ₹20
Net profit = ₹8200-₹8000-₹20
= ₹180
This is kind of arbitrage
practice. In India there are two major stock exchanges.
1.NSE (National Stock Exchange)
2.BSE ( Bombay Stock Exchange)
1
Now I noticed that Berger
Paint’s share is trading at ₹225 in BSE while trading at ₹223 in
NSE. I will immediately Sell shares in BSE and buy the same shares in NSE. I
will gain ₹2 per share without any analysis.
But the important point to
notice is there are less likely situation where we will get chance to make
arbitrage profit. There are many FIIs who only do arbitrage because they have
advanced software, automated machines who take trade automatically. You have to
be very fast in this game. You have to be absolutely attentive.
I hope this post helps you
to understand what is hedging and what arbitrage is. If you have any questions
then you can ask in comment box. Constructive suggestions are always welcome.
Thank You.
Stay Healthy, Happy
Investing.
Sources of information
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