Speculation and Hedging

Speculators are those who do not have any position on which they enter in futures and options market. They only have a particular view on the market, stock, commodity etc. In short, speculators put their money at risk in the hope of profiting from an anticipated price change. They consider various factors such as demand and supply, market positions, open interests, economic fundamentals and other data to take their positions. Stocks carry two types of risks – Company specific and market risk while company risk can be minimized by diversifying your portfolio, market risk cannot be diversified but has to be hedged, so how does one measure the market risk? Market risk can be known from Beta. Beta measures relationship between movements of the index to the movement of the stock. The Beta measures the percentage impact on the stock price for 1% change in the index, therefore, for a portfolio whose value goes down by 11% when the index goes down by 10% the beta would be 1.1 when the index increases by 10% the value of the portfolio increases 11%. The idea is to make beta of your portfolio zero to nullify your losses. Hedging involves protecting an existing asset position from future adverse price movements. In  order to hedge a position, a market player needs to take an equal and opposite position in the futures market to the one held in the cash market. Every portfolio has a hidden exposure to the index, which is denoted by the beta.