Strategies are game plans created by an investor. These game plans are based on an investor’s expectations of how the market will move. Usually, there are four views that an investor can take on market movements: bullish, bearish, volatile and neutral.
Bullish: The investor anticipates a price rise.
Bearish: The investor anticipates a price decline
Volatile: The investor anticipates a significant and rapid movement either in the market or scrip but he is not clear of the direction of the movement.
Neutral: The investor believes that market or scrip will not move significantly in any direction. It is opposite of the volatile view.
Different strategies are available for different views on market movements. These strategies can be classified into three groups:
i) Hedging strategies
ii) Speculative trading strategies
iii) Arbitrage strategies
Hedging with Index Futures:
Futures contracts in India are available on two stock indices – S&P CNX Nifty and BSE Sensex. A hedge reduces the price risk of an existing or anticipated position in the cash market. A hedge can help lock in existing profits. Hedging does not mean maximization of return. Its purpose is to reduce the volatility of a portfolio by reducing the risk. Stock index futures are used to reduce stock market risk in the anticipation that any losses arising from movements in stock prices are offset by gains from parallel movements in futures prices. Hedgers sell futures when they are long the cash asset and buy futures when they are short the cash asset.
In stock index futures, there is no delivery and receipt of stock. Stock index futures contracts are cash settled.
It is necessary to know the beta of a stock to measure the extent to which it moves in line with the market index. The market index is assumed to have a beta (β) one (1). A stock with a beta of 0.5 is half as volatile as the market index and a stock with 2 is one with double the degree of volatility. If the β of a stock is 1.2 then the stock tends to change by 20 percent more than the stock index. The relatively large losses (or profits) arising from high volatility require correspondingly large offsetting profits (or losses) from futures contracts and thus a large number of futures contracts.
Stock index futures are of immense importance to mutual funds.
Some examples where hedging strategies are useful for mutual funds are:
i) reducing the equity exposure of a mutual fund by selling index futures
ii) investing funds raised by new schemes in index futures so that market exposure is immediately taken
iii) partial liquidation of portfolio by selling the index future instead of the actual shares where the cost of transaction is higher.
Besides mutual funds, stock index futures help in neutralizing market volatility, arising out of sudden changes from the FII flow of funds.
There are four hedging strategies in case of index futures
1. Long stock, short index futures
2. Short stock, long index futures
3. Hedging a portfolio with short index futures
4. Hedging with long index futures
Long Stock, Short Index Futures: An investor might be a skilled stock picker but a poor market timer. He might feel that the stock is intrinsically undervalued but the entire market may move against his thinking even though it is correct. His understanding that the stock is intrinsically undervalued is wrong and the stock is not worth more than the market price. Hence to remove risk from fluctuations of the market index, he takes a long position in a stock plus short position in index. With this strategy, he was hedged his index exposure.