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One of my regular blog readers in USA asked a great question in the article hedging vs stop loss which is better: In simple language he asked if one can buy an Index Future and hedge it with buying Puts in its ETF?
In India that question converts to if you can buy Nifty Future and hedge it with buying put of any electronic trading fund that mimics Nifty like Nifty BeES.
Unfortunately we don’t have options trading on ETFs here in India. Even if it was done it does not make sense to hedge Nifty Future with and option of a Fund.
There is one major reason for it and that is one unit (or lot) of the ETF fund will never match one lot size of Nifty in terms of cash. It will almost always be very small in size in terms of total value in Rupees.
ETFs usually have very small cash size. There is a reason for it – so that even those with not much money to invest in stock markets may be able to participate in its growth. Like in most equity mutual funds in India you can start a SIP for Rs. 500 per month.
In the Goldman Sachs Nifty ETS Fund (an electronic trading scheme fund that mimics Nifty a.k.a Nifty BeES) the minimum investment is Rs. 10000/- and any additional investment thereof is Rs. 1000/- only. If options is allowed here the ticket size will be too small to hedge anything against Nifty.
According to NSE website: Nifty BeES trades on the Capital Market segment of NSE. Each Nifty BeES unit is 1/10th of the S&P CNX Nifty Index value. Nifty BeES units are traded and settled in dematerialised form like any other share in the rolling settlement.
So essentially if you hedge you are only hedging 1/10th of your trade. In simple language its not technically a hedge to hedge Nifty Futures with Nifty BeES.
I wrote the same reply to Michael:
Hope the article helps you trade profitably there in the USA.
To answer your question I am not comfortable hedging one instrument with another instrument even if they are related. That's not real hedging. I also see that there is a huge difference between dollar value of one contract of NQ and dollar value of one contract of ETF. In fact there is BIG difference – the ratio of NQ:QQQ stands at 1:800 approx.
There is no way you can hedge it with buying cheaper puts of QQQ. Please remember whenever you hedge the dollar value of both contracts should be same. Agreed ETFs are cheaper but they will be helpless in case there is a crash. The kind of money you make from puts will be negligible.
If you really want to save money, then buy slightly out of the money puts. They will also give a great protection – but it starts only after some loss is taken. ATM options are costly but they start protecting from day 1. You lose some, you gain some – that's the puzzle you need to solve.
In the US if you don’t know that volumes are so huge that even ETFs have options, commodities like Gold, Silver, Crude have options. There is LEAP that is options expiring after years – even they are highly traded.
In finance, LEAPS (an acronym for Long Term Equity AnticiPation Security) are options of longer term until expiry than other, more common, options. LEAPS are available on approximately 2500 equities and 20 indexes. As with traditional short term options, LEAPS are available in two forms, calls and puts.
LEAPS were created relatively recently and typically extend for terms of 2 years out. Equity LEAPS always expire in January. For example, if today were November 2014, one could buy a Microsoft January call option that would expire in 2015, 2016, or 2017. The latter two are LEAPS.
In fact in US option spreads are traded as one single trade for the difference between them unlike in India where we have to trade two different legs and we are not sure exactly what points we are going get.
Trades are asking SEBI to at least block as margin the max loss that is possible in a debit or a credit spread, but for reasons better known to them they are still blocking full margin.
Update: Oct 30, 2019 – SEBI may lower margin requirements for hedged trades in F&O segment. Read more here – this is a good news if you have done my course:
For example if you buy an option for 10 and sell another OTM option for 5. In the US only 5+brokerage will be blocked as margin whereas here in India the brokers will ignore the buy and block full margin for the option sold.
SEBI’s reasoning is volumes. They say if any option goes deep in the money and there are less traders and the ask bid price has too much gap, the losses can be more than the max blocked. Unfortunately until this exists we have to trade whatever is given to us.
But once the rule changes we can trade many more lots with the same cash in our account. In that case the returns from the hedged trades will be even more. People who have taken my course can then make even more. 🙂
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