Short hedge
Also written Selling hedge
A hedge made by selling futures to protect an existing holding or a planned sale against a price fall — the futures gain offsets the lower cash price, locking in roughly the futures price.
In plain language
A short hedge protects someone who owns something, or will sell it later, and is afraid the price will fall before then.
The workbook's definition: short hedge is a transaction when the hedge is accomplished by going short in futures market. Its example: you hold a portfolio you plan to liquidate soon, but fear prices will fall first. Short index futures of an equivalent amount today, and the loss in the cash market will be partly or fully compensated by the profit on the futures.
The classic textbook case in Chapter 3 is the farmer who sells futures to lock in a price for a crop he will deliver later, and the investor with a diversified portfolio who sells index futures to protect against a temporary market correction.
As with every hedge, the protection is two-sided. If prices rise instead, the shares fetch more but the short futures lose. The effective selling price settles close to the futures price at which you went short.
How it works
- Single stock: short stock futures, lots matched to the number of shares (hedge ratio 1:1).
- Portfolio: short index futures, with the number of contracts set by the beta-based hedge ratio.
- Contract month: the one that expires just after the planned sale date. The workbook's example: on 10 May an investor decides to sell his portfolio on 20 June — he should short the June contract, not May.
- Unwind: sell in the cash market and buy back (square off) the futures together.
Chapter 3 notes that a short hedge of a portfolio using index futures is, strictly, a cross hedge, because the index is not the exact asset being protected.
The formula
Net sale proceeds = Cash sale proceeds + Gain on futures (or − Loss on futures)
Effective price per share = Net proceeds / Number of shares
A worked example
The workbook's example (Chapter 5, section 5.1). On 10 May you plan to sell 1,200 shares of PQR Ltd on 10 July to repay a personal loan. Spot Rs 1,690; July futures Rs 1,706; lot size 600. Short 2 lots.
Scenario 1 — price falls. On 10 July spot Rs 1,440, futures Rs 1,441.
| Rs | |
|---|---|
| Cash sale 1,200 × 1,440 | 17,28,000 |
| Add gain on futures (1,706 − 1,441) × 600 × 2 | (+) 3,18,000 |
| Total received | 20,46,000 |
| Per share | 1,705.00 |
Scenario 2 — price rises. On 10 July spot Rs 1,800, futures Rs 1,802.
| Rs | |
|---|---|
| Cash sale 1,200 × 1,800 | 21,60,000 |
| Less loss on futures (1,802 − 1,706) × 600 × 2 | (−) 1,15,200 |
| Total received | 20,44,800 |
| Per share | 1,704.00 |
Whether PQR fell Rs 250 or rose Rs 110, the effective sale price stayed within Rs 2 of the Rs 1,706 futures price.
Why NISM asks about it
Chapter 3, section 3.9, defines the short hedge and the hedge contract month rule. Chapter 5, section 5.1, works the PQR Ltd example above and then extends it to hedging a whole portfolio with index futures using beta. Expect "which hedge?" identification and effective-price arithmetic.
Common exam traps
- Protecting a holding or planned sale → short hedge.
- Count lots correctly: 1,200 shares ÷ 600 lot size = 2 lots. Using 1 lot leaves half the position unhedged.
- The short hedge gives up the upside — Scenario 2 shows it.
- Pick the contract that expires after the sale date. For a 20 June sale, the June contract, not May.
- Hedging a stock portfolio with index futures protects against systematic (market) risk only; stock-specific risk remains.
Where this is taught
- Series IV · Chapter 5: Strategies using Interest Rate Derivativesintroduced here
- Series XVI · Chapter 5: Uses of Commodity Derivativesintroduced here
- Series VIII · Chapter 5: Strategies using Equity Futures and Equity Optionsintroduced here
- Series V-D · Chapter 22: Strategies using Interest Rate Derivativesintroduced here
Related terms
- BetaHow sharply a share moves relative to the market index — beta 1 moves with the index, above 1 amplifies it, below 1 dampens it. The standard measure of systematic risk.
- Hedge ratioThe number of futures (or options) needed to hedge a position. For one stock with its own futures it is 1:1; for a portfolio against index futures it is portfolio value × beta ÷ contract value.
- Systematic riskThe part of an investment's risk that comes from economy-wide forces moving every asset at once — it cannot be diversified away, and it is the only risk the market pays you to carry.
- Futures contractA standardised forward traded on an exchange, where the exchange fixes every term except the price and the clearing corporation guarantees settlement, so neither side carries the other's default risk.
- HedgerA participant who already carries interest rate risk from a real business exposure and uses derivatives to remove it, rather than to take a view on the market.
- Long hedgeA hedge made by buying futures to protect against a price rise before a planned future purchase — the gain on futures offsets the higher cash price, locking in roughly the futures price.
- Cross hedgeHedging an exposure with futures on a different but closely associated asset, because no futures contract exists on the asset itself — for example, hedging a stock portfolio with index futures.
- Risk transferThe economic function by which commodity price risk moves off the hedger, who does not want it, onto the speculator, who is willing to carry it for a return.
- Strengthening basisA change in basis (spot minus futures) towards a more positive or less negative number — spot rising relative to futures — which benefits a short hedger.
- Naturally longThe position every business holds in its finished goods — it gains when their prices rise and loses when they fall, which is why finished goods are hedged by selling futures.
- Naturally shortThe position every business holds in its raw materials — it must buy them in future, so a price rise hurts it exactly as a short position would, and a long hedge cancels the exposure.
- Offsetting hedgeA hedge undertaken to offset price risk that has arisen from a physical market activity already carried out — one of the workbook’s two basic hedging strategies, the other being locking in a price.
- Short positionAn outstanding, unsettled sell position in a derivatives contract — the seller of a futures contract, or the seller (writer) of an option, is said to be short.