Stock Market: Why is hedging crucial for success in the Indian derivatives market?

The Indian derivatives market is often criticised for fostering speculative trading, but its primary function is to provide effective risk management strategies, such as hedging. Unfortunately, SEBI’s recent regulatory proposals overlook the significance of hedging, especially in enhancing risk-adjusted returns, even when these strategies might appear less profitable in the short term.

The protective put strategy: A case in point

Consider a protective put strategy where an investor buys a single monthly put option every month to hedge against potential losses in a stock or index. While this strategy may frequently result in a net loss due to the cost of purchasing the put options, it plays a crucial role in improving overall risk-adjusted returns, as measured by the sharpe ratio.

Let’s take two traders who invested in the Nifty 50 index starting in 2019. The first trader invested ₹10 lakh and followed a simple buy-and-hold strategy. Over this period, the trader would have earned a return of 13.35%, with a sharpe ratio of 0.7043—a metric that indicates the amount of excess return generated per unit of risk taken.

In contrast, the second trader employed a protective put strategy, allocating ₹8.5 lakh to the Nifty 50 and holding ₹1.5 lakh in cash to purchase a single monthly put option with a 30% stop loss. Despite achieving a lower absolute return of 12% due to the cost of the put options, this strategy resulted in a higher sharpe ratio of 0.7238.

This indicates that for every additional unit of risk taken, the second trader achieved a better risk-adjusted return than the first trader, who only held nifty without any hedging.

SEBI's misclassification of hedging strategies

SEBI’s proposal, unfortunately, lumps traders using hedging strategies like the protective put into the category of loss-making traders, which couldn’t be further from the truth.

For instance, this strategy broke even in 2019, lost money in 2021, 2023, and so far in 2024, but was profitable in 2020 and 2022. Notably, during the COVID-19 crash in 2020 and the months when the Ukraine crisis unfolded—periods that were particularly challenging for equities—this strategy performed exceptionally well.

The protective put provided substantial downside protection, thereby validating its role as a hedge and contributing to the improved sharpe ratio. This underscores that while the strategy might incur losses in calm market conditions, it shines when the market is in distress, fulfilling its primary purpose of risk management.

The cost of hedging: A necessary trade-off

The protective put strategy demonstrates that while hedging may reduce total returns in absolute terms, it significantly enhances risk-adjusted returns by lowering portfolio volatility.

Additionally, the remaining portion of the ₹1.5 lakh cash component after buying the put could be invested in an income-generating instrument like LiquidBees, earning an extra 3-4% on that amount annually.

This added income would further improve the sharpe ratio and returns, illustrating that even a relatively unoptimised protective put strategy can outperform the simple buy-and-hold nifty strategy on a risk-adjusted basis.

Conclusion: Recognising the value of hedging

The protective put example illustrates that hedging is not just about avoiding losses but about optimising risk-adjusted returns. SEBI’s proposed regulations must differentiate between speculative activities and hedging strategies that enhance market stability and investor confidence. Effective regulation should support, not stifle, the use of derivatives for risk management, ensuring that the market remains robust, liquid, and fair for all participants.

Raghav Mallik, Co-founder, Algo test