Chapter 04 · Futures contracts
Hedging and the basis
A hedge is a second position that loses money when your real exposure makes money, and makes money when your real exposure loses it. The basis is the gap between the futures price and the spot price. This chapter shows a stock hedge, where the basis moves, and why a hedge that is ‘on’ can still wobble.
The purpose is a smaller swing, not a profit
Suppose you hold 1,000 shares at ₹250, a ₹2,50,000 position, and you are not allowed to sell them this month — a lock-in, a tax date, or simply a decision you have made. You are worried about the next few weeks, not about the next five years. Selling futures against the holding means a fall in the shares is roughly offset by a gain on the short futures. A rise in the shares is roughly offset by a loss on the futures. You have chosen a quieter month in exchange for giving up the quieter month’s upside. If that trade-off feels disappointing, you wanted a speculation, not a hedge.
Work the numbers, including a basis that changes
The shares are ₹250. The near futures are ₹253. The basis is futures minus spot, so +₹3. You sell futures on 1,000 shares at ₹253. Three weeks later the shares are ₹230 and you buy the futures back at ₹231. The basis is now +₹1.
| Leg | Start | End | Result |
|---|---|---|---|
| Shares | ₹250 | ₹230 | Loss ₹20 × 1,000 = ₹20,000 |
| Short futures | Sold ₹253 | Bought ₹231 | Gain ₹22 × 1,000 = ₹22,000 |
| Net, before charges | Gain about ₹2,000 |
You were hedged, and you still made ₹2,000, because the basis narrowed from ₹3 to ₹1 and you were short the future. Had the basis widened to ₹6 while the share fell to ₹230, the future would have been ₹236, and the futures gain would have been only ₹17 a share, or ₹17,000, against a ₹20,000 share loss. The net would have been a ₹3,000 loss before charges. The hedge worked in the sense that a ₹20,000 hole became a ₹3,000 hole. It did not work in the sense of a perfect offset. Basis is the residue a hedge does not remove.
Imperfect hedges are the usual kind
You may not have a future on the exact share. A portfolio hedge uses an index future. The portfolio can fall while the index rises. That gap is basis of a messier sort, usually called tracking difference or beta mismatch. If your stocks are more volatile than the index, an equal rupee hedge will under-hedge them. If you sell too many index futures, you are no longer hedging. You are net short, and a rally becomes your loss. Write down the rupee exposure of the shares and the rupee exposure of the futures. The difference is the risk you chose to keep.
When to take the hedge off
A hedge has a review date, just as a speculation does. The lock-in ends, the tax date passes, or the event you feared has either happened or expired. Leaving the short future on after the reason is gone means you are now short a market you still hold. That is a new decision. Make it on purpose. Also take the hedge off, or resize it, if the basis has moved so far that the protection you are buying is mostly a bet on the basis returning. At that point you are running two trades. Name them separately.
What to remember
- A hedge pays for protection by giving up the gain on the thing you already own.
- Basis is futures minus spot. A change in basis is a gain or a loss the share move does not cancel.
- An index future hedges an average, not your exact holdings.
- Match rupee exposure to rupee exposure. Extra futures are a new short, not a sturdier hedge.
- Remove the hedge when the reason for it ends.