Option Hedging Strategies

Indian markets are known for their volatility. Global cues from the US, crude oil price swings, RBI announcements, or sudden geopolitical events can trigger sharp overnight moves. For traders and investors, reacting after the move is often too late.

This is where option hedging strategies become essential. Hedging is not about maximising profits; it is about protecting capital and managing risk.

In this blog, you’ll learn what is hedging in option trading, how to hedge stocks and indices like Nifty, commonly used futures and options hedging strategies, their costs, and how to choose the right hedge for your trading style in the Indian market.

What is Option Hedging?

In simple terms, hedging in option trading means taking an offsetting position to reduce potential losses in your main portfolio. It allows you to protect your capital without having to sell your favourite stocks. It’s like paying an insurance premium; you cap your downside while retaining the potential for future gains.

Why Traders Hedge?

In India, markets are prone to overnight gaps. If a global event happens while the NSE is closed, a standard "Stop Loss" may not protect you because the stock could be significantly lower than your trigger price. For example, if a stock closes at ₹1,000 and opens the next day at ₹950 due to global developments, a stop-loss at ₹980 provides no protection. A Put option, however, continues to exist irrespective of market hours and offers predefined downside protection.

The "Cost" of Peace of Mind

Just like car insurance, hedging isn't free. When you hedge in the Indian market, you face two primary costs:

• Option Premium: This is the upfront amount paid to purchase the option. It is the maximum possible loss on the hedge.
• Time Decay (Theta): Options are time-bound instruments. As expiry approaches, their value erodes if the market does not move in the anticipated direction. This decay accelerates significantly during the final days before expiry.

Hedging Stocks with Options (Equity Hedging)

If you hold a significant position in a stock like HDFC Bank, you don’t have to sell your shares just because you fear a temporary dip. Instead, you can use a Protective Put.

Hedging Example: HDFC Bank

In the Indian F&O segment, HDFC Bank has a lot size of 550 shares. To have a "perfect hedge," your quantity should be a multiple of this.

• The Position: You hold 550 shares of HDFC Bank at ₹1,500.
• The Hedge: You buy one 1480 Put Option at a premium of ₹20.
• Total Hedge Cost: 550 X 20 = ₹11,000

The Outcomes:

• Market Crash (Price hits ₹1,400): Your shares lose ₹100 X 550 = ₹55,000. However, your 1480 Put is now worth at least ₹80. Your profit on the Put is (80 -20) X 550 = ₹33,000. Your net loss is capped at ₹22,000 instead of ₹55,000.
  
• Market Rally (Price hits ₹1,600): Your shares gain ₹55,000. Your Put expires worthless (loss of ₹11,000). Your net profit is ₹44,000. You essentially paid a "security fee" to stay invested.

The Lot Size "Matching" Problem

This is the most common mistake for beginners. In India, stock options are all-or-nothing based on the lot size.

• If you own 200 shares: You cannot use HDFC Bank options effectively. Buying 1 lot (550 shares) makes you "over-hedged"; if the stock goes up, your loss on the 550-share Put will wipe out the gain on your 200 shares.
• The Proxy Solution: For "odd lots" or small portfolios, use Nifty Puts. Since HDFC Bank is a heavyweight in the Nifty 50, a Nifty Put will move in a similar direction, providing a "proxy hedge" for your smaller holding.

Physical Settlement & Expiry Considerations (Stock Options)

SEBI mandates physical settlement for all stock derivatives.

Practical Implication

If a stock option expires In-the-Money (ITM), it may result in delivery or receipt of shares, along with additional margin, settlement obligations, and taxes.

Best Practice

Most retail traders:

• Square off or roll over stock option hedges before the expiry week ends
• Avoid unintended exercise/assignment and potential liquidity or tax complications

Note: STT rates and settlement charges vary by transaction type. Always confirm applicable charges with your broker and the latest NSE circulars.

Hedging with Nifty & Bank Nifty Options (Index Hedging)

If you hold a basket of 10–15 stocks, it is expensive and complicated to buy Put options for each one. Instead, traders use Index Hedging to protect the entire portfolio at once using Nifty or Bank Nifty options.

The Strategy: Beta-Weighted Hedging

Not all portfolios are created equal. If your portfolio consists of high-growth mid-cap stocks, it will likely fall more than the Nifty during a crash. To fix this, we use "Beta."

• Portfolio Value: ₹10 Lakhs.
• Portfolio Beta: 1.2 (This means if Nifty falls 1%, your portfolio is expected to fall 1.2%).
• Hedge Requirement: You need to hedge ₹10 Lakhs X 1.2 = ₹12 lakhs worth of Nifty.

Example Execution:

1. Nifty Level: 24,000.
2. Contract Value: 24,000  X 65 (Lot Size) = ₹15,60,000 (₹15.6 Lakhs).
3. Determine the Number of Lots:

Formula: Target Hedge Value/New Contract Value

Calculation: 12,00,000/15,60,00 = 0.769 Lots

To execute this in the real market, you simply round up to 1 lot (65 units) and accept being slightly over-protected, or blend it with other index options like Bank Nifty for a more precise match.

Pro-Tip: The "VIX" Rule

Before you buy protection, look at the India VIX (often called the "Fear Gauge").

• When VIX is Low (<15): Hedging is cheap. This is the best time to buy "insurance" for your portfolio.
• When VIX is High (>20): Options are already very expensive. At this stage, buying a Put might cost so much that it eats away your long-term profits. In such cases, professional traders often use Spreads (like a Bear Put Spread) to reduce the cost of the hedge.

Common Mistake: Choosing the Wrong Index

Don't hedge a portfolio of Banking stocks with the Nifty 50. If you hold SBI, HDFC Bank, and ICICI Bank, your portfolio will correlate much better with Bank Nifty. Using the wrong index for hedging is called “Basis Risk,” where the index stays flat but your stocks crash anyway.

Understanding the Cost of Hedging

Hedging is like buying a car insurance policy. You hope you never have to use it, but you pay a "premium" to keep it active. In option trading, this premium is influenced by a silent profit-eater:

1. Time Decay Acceleration: Options are "wasting assets." Every day that the market stays flat or moves in your favour, the value of your Put option decreases.

• The Theta Ramp: Time decay is not linear. It accelerates as you get closer to the expiry date. A Put option loses value much faster in the last 7 days of the monthly expiry than it does in the first 7 days.
• Monthly vs. Weekly: For Nifty and Bank Nifty, you have weekly expiries. While weekly Puts are cheaper, they decay at a lightning-fast rate. Most long-term investors prefer Monthly Puts for hedging to avoid being killed by rapid time decay.

2. Delta Your Hedge Efficiency: Not all put options provide the same amount of protection. This is measured by Delta.

• At-The-Money (ATM) Puts: Usually have a Delta of around -0.50. This means if Nifty falls by 100 points, your Put will gain roughly 50 points.
• Out-of-the-Money (OTM) Puts: Have a lower Delta (e.g., -0.20). These are "cheap" but will only start protecting you after a very large crash.

3. Bid-Ask Spread: Liquidity matters.

Example:

• Bid price: ₹20
• Ask price: ₹22

If you buy at ₹22 and can immediately sell only at ₹20, the implied slippage is ~9.1%.

Always check open interest and spreads before entering hedges.

Common Options Hedging Strategies Used in India

In the Indian derivatives market, options are widely used not just for speculation but for professional risk management. Below are the most effective strategies for retail traders, updated with the latest SEBI norms.

1. Protective Put: A Protective Put involves buying a Put option against an existing stock or futures position. This strategy sets a floor on losses while allowing unlimited upside.

• Market View: Bullish long-term but worried about immediate volatility (e.g., Earnings or Election results).
• The Trade: Buy 1 Put Option for every lot of stock or index futures you hold.
• 2026 Update: Note that for contracts expiring from January 2026 onwards, the Nifty lot size is 65 and Bank Nifty is 30. Check current NSE circulars for lot sizes; adjust quantity to match contract specifications.
• Why it’s popular: It’s the simplest "low-cost hedge." If the market crashes, your Put gains value, effectively capping your loss at the strike price.

2. Covered Call: In a Covered Call, you sell a Call option against shares you already own. The premium received provides limited downside protection.

• Market View: Neutral to slightly bullish. You expect the stock to stay flat or rise slowly.
• The Trade: Hold the stock and sell (Write) an Out-of-the-Money (OTM) Call option.
• Key Benefit: You collect the premium (income). This premium acts as a small cushion if the stock falls.
• The Indian Nuance: Since you are "Selling" an option, you would normally need a high margin. However, in India, if you hold the shares in your Demat, many brokers allow you to use them as collateral, reducing the cash needed for the trade.
• Risk: If the stock "caps upside" (rallies 20%), your profit is capped at the strike price. You might be forced to sell your shares.

3. The Collar: A Collar combines buying a Put (downside protection) and selling a Call (to fund the Put). This results in low-cost or zero-cost hedging.

• Market View: Cautious. You want protection but don't want to pay for the "insurance premium."
• Why it’s popular in 2025: With India VIX being unpredictable, Put premiums can be expensive. The Collar strategy often results in reduced net premium outlay, meaning your insurance is essentially free, provided you are willing to cap your upside.

4. Bull Call / Bear Put Spreads: If you find a single Put option too expensive, use a Spread.

• Bear Put Spread: Instead of just buying a 24,000 Put, you buy the 24,000 Put and sell a 23,500 Put.
• Benefit: This significantly lowers your "Theta Decay" (time decay) and total cost. Under SEBI’s 2025 Margin Rules, hedged spreads now receive significant margin benefits, making them much more capital-efficient than naked selling.

Pro-Tip: The "Margin" Advantage

One of the best things about hedging in India today is Margin Benefit. If you sell an option as part of a hedge (like in a Collar or Spread), your broker will significantly reduce your required margin compared to a 'naked' sell position. Always check your broker’s margin calculator to see how much capital you can save by simply adding a hedge.

How to Choose the Right Hedging Strategy?

Selecting a hedge isn't a one-size-fits-all decision. It depends on your "Risk Priority." Use the table below to identify your current situation:

Pro-Tips from the Trading Floor

1. The VIX "Buy vs. Sell" Rule:

In India, the India VIX tells you how expensive "insurance" is.

• Low VIX (<15): Buy a Protective Put. Insurance is cheap; lock it in.
• High VIX (>22): Don't buy naked Puts. Instead, use a Collar or Spread. Since you "Sell" an option in these strategies, you benefit from the high premiums other people are paying.

2. Delta Sensitivity:

Beginners often buy "Far Out-of-the-Money" (OTM) Puts because they cost only ₹5 or ₹10.

• The Reality Check: These options have a very low Delta (around 0.10). This means if Nifty falls by 100 points, your hedge only gains 10 points.
• The Rule: If you want real protection against a 2-3% dip, choose a strike price with a Delta of at least 0.40 to 0.50 (usually At-The-Money).

3. Systematic vs. Unsystematic Risk:

• Hedging a single stock: Use its specific Stock Option (Watch out for Physical Settlement!).
• Hedging a 20-stock portfolio: Don't buy 20 different Puts. Calculate your Portfolio Beta and buy the equivalent value in Nifty Puts. It’s cheaper, more liquid, and easier to manage.

4. SEBI Margin & Tax Efficiency (LTCG):

• Margin Benefit: Under SEBI’s 2025 rules, buying a hedge (like a Put) while selling a Call (the Collar) significantly reduces your required margin. Always use a margin calculator to see how "spread benefits" save your capital.
• The Tax Shield: As of the latest budget, LTCG tax is 12.5% for gains above ₹1.25 lakh. Selling your stocks to avoid a crash triggers this tax. Hedging with Puts allows you to keep your stocks, maintain your holding period, and protect your capital without a tax "exit fee."

Benefits of Hedging With Options

Professional traders in India don't view hedging as an optional expense; they see it as a mandatory "cost of doing business." Here is why:

1. Defined and Limited Risk:

When you buy a Put option to hedge, your maximum loss is fixed from day one. Even if the Nifty crashes 10% overnight due to a global crisis, your portfolio has a "floor." You know exactly how much you can lose, which is the hallmark of a professional trader.

2. Capital Efficiency & Margin Benefits:

In 2025, SEBI's margin rules significantly favour hedged positions.

• Span Margin: If you sell a Call (Covered Call) or enter a Spread, your broker will block much less margin than a "naked" position because your risk is capped.
• Collateral: You can pledge your existing long-term stock holdings to get a trading limit, allowing you to execute hedges without bringing in extra cash.

3. Tax Efficiency (Preserving LTCG):

One of the biggest hidden benefits in India is tax savings. If you fear a correction and sell your stocks to avoid a loss, you might trigger LTCG (Long-Term Capital Gains) tax of 12.5% (for gains above ₹1.25 lakh). By hedging with Puts instead of selling, you keep your holding period intact. If the market recovers, you’ve avoided a massive tax bill while still protecting your capital.

4. Better Emotional Discipline:

Market volatility often leads to "Panic Selling" at the bottom. A hedge acts as a psychological anchor. Knowing you are protected allows you to stay invested through the "noise," ensuring you don't miss the eventual recovery.

5. Ability to stay invested during "Black Swan" events:

Events like sudden geopolitical shifts or unexpected RBI policy changes can't be predicted. Hedging ensures that while others are panicking, your portfolio remains stable, giving you the "peace of mind" to make rational decisions.

Conclusion

Understanding what is hedging in trading changes how you approach the market. Instead of reacting to volatility, you prepare for it.

Whether it’s equities, Nifty, or future and option hedging strategies, options give Indian traders a powerful way to manage uncertainty. When used correctly, hedging doesn’t reduce opportunity; it protects longevity in the markets.

Image Reference - Add payoff diagrams for the Protective Put and Covered Call to help them visualise the "floor" and "ceiling."