Question

Suppose that your uncle informs you that he is now contemplating hedging his 10,000 share portfolio using futures contracts. Precisely explain and specifically detail the steps involved in hedging his share portfolio using futures contracts

Answer 1

Hedging- It is a risk mitigating technique. Stock market is volatile and uncertain, risk is the uncertainty that may occur in the future so to minimize or to avoid this risk, investors and traders use Futures contract.

Futures contract- Futures contracts are the derivative contracts that are used to hedge the risk involved in underlying securities and financial markets. Futures is an agreement between two parties to buy or sell a particular underlying asset at a predetermined price and at a specific date in the future.

Long hedging- If you uncle want to buy gold in the future, current price of gold is $42/gm but six months contract is available at $40/ gm then he will now buy a future contract and lock in the price that is $40/gm.

Short hedging- This is widely used hedging in derivatives. If uncle wants to sell silver in the future and the current price of silver is $12 while 3 months silver contract is trading at $11 then he will take a short position in silver today and will cover it after 3 months when price comes down. He will get profit.