How Investors Can Use Futures to Hedge Against Market Downturns
Futures markets are popular among many active traders for at least a few reasons. Futures trading is, well, about the future—trying to gauge where prices for a certain commodity, stock index, or other asset may be next week, next month, or next year.
Many professional investors and traders use futures to hedge against potential market downturns. For example, they may attempt to protect or insulate their portfolios against “black swan” events, such as a financial crisis or unexpected election outcome, or against smaller-scale disruptions that roil equity prices, even if just briefly.
Individual investors can also use futures contracts linked to the S&P 500 Index (/ES), the Nasdaq-100 (/NQ), or other equity benchmarks to hedge their portfolios against market volatility and slumps. That said, before investors venture into the futures arena, they should first educate themselves on the workings of the futures market and understand the risks, suggested Adam Hickerson, senior manager of futures and forex at TD Ameritrade.
Why would investors consider futures-based hedging strategies? “One big reason,” Hickerson said, “is capital efficiency.”
Eyes Open for Global Event Risk
A futures contract is an agreement to buy or sell a predetermined amount of a commodity or financial product on a specified date. Futures are traded on exchanges and span a variety of asset classes: stock indices, interest rates, currencies, and commodities such as crude oil, gold, soybeans, and more.
Futures contracts are also typically highly leveraged, meaning that by putting a relatively small amount of money down, you can control a relatively large amount of underlying value (often referred to as “notional” value). That’s where capital efficiency comes in, Hickerson explained.
Say you hold shares of companies you think are solid investments over the long haul but might get dinged by outside events with a limited, short-term impact. A futures-based hedging strategy offers the potential to weather such events without having to part with shares you hold near and dear.
“Don’t want to reduce any portfolio positions but concerned about an upcoming event, such as an economic report or an election? Qualified traders might consider using futures to hedge such a portfolio,” Hickerson said. And because futures are leveraged, you don’t have to use a lot of capital to hedge a large portfolio. But note: leverage is a double-edged sword—it can magnify your gains, but also your losses. So a small amount of market movement can have a large effect—positive or negative—on an account’s profit and loss.
Another benefit: futures are available for trading nearly 24 hours a day, six days a week. “You have the ability to hedge your portfolio around the clock,” Hickerson noted. “This is important because events that may occur outside U.S. equity market hours may impact your portfolio. Futures offer the flexibility to provide hedging capabilities when the equity market is closed.”
Basics of Beta Weighting
One futures-based hedging approach involves calculating beta and allaying beta weighting. Beta measures the volatility of an individual asset or an entire portfolio in comparison to a benchmark such as the S&P 500 Index.
How can investors apply bet weighting to hedge a portfolio? With beta weighting, think of hedging as an attempt to reduce your portfolio’s delta. As a reminder, delta is the approximation of the change in the price of an option relative to a change in the price of the underlying stock, with all other factors held constant. If your portfolio has positive delta, but you think the market might drop, consider reducing your delta exposure. You can do this by adding a position with negative delta—a short E-mini S&P 500 futures contract, for example.
If you know how many positive deltas are in your overall portfolio and how many negative deltas a short E-mini S&P 500 futures contract has, you can determine how many futures contracts to sell to hedge your portfolio.
For example, if your portfolio has 447 deltas, one E-mini S&P 500 futures contract would add negative 50 deltas. Based on these numbers, if the S&P 500 fell one point, the original portfolio would fall an estimated $447. However, the portfolio with the futures hedge would only fall $397.
One of the main benefits of beta weighting is that you can see the risk associated with each of your positions expressed in the same unit. If you’re bullish, you’ll want to see more positive deltas. If you’re bearish, you’ll want fewer positive deltas, or even negative deltas.
“You’re essentially looking at what your portfolio would do if there’s an increase or decrease in the overall stock market,” Hickerson explained. “You can beta weight your entire portfolio.”
Let’s take one simplified futures-based hedge example. Suppose you hold a stock position or a portfolio of stocks with a value of $425,000, and you’re concerned about the prospect of negative surprises in upcoming economic reports or earnings season.
You might consider hedging about 30% of that portfolio by selling (or shorting) one e-mini S&P 500 contract (ticker /ES) by putting up the initial margin, which is $6,930 as of mid-May 2019. Because the notional value of one e-mini S&P 500 contract is $50 times the index price, with /ES at 2,860, the initial margin would represent about 4.8% of the notional value:
($50 x 2,860) = $143,000
$6,930/$143,000 = 0.048 or 4.8%
If the S&P 500 drops 50 points (about 1.7%), you might then consider buying back, or “closing out,” that futures position and pocketing a gain of $2,500 that could help offset any unrealized losses in your stock portfolio. By taking a position in the futures contract, you gain similar notional exposure while tying up a lot less capital.
Long or short, if you’re considering hedging a portfolio, or part of one, futures can be a useful tool for capital efficiency. But futures aren’t for everyone, and not all accounts will qualify. Additional education about futures contracts, margin, and beta weighting can help you decide if such a strategy is right for you.
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Article initially appeared on “The Ticker Tape” - TDAmeritrade
Credit: Bruce Blythe, TDAmeritrade, WSJ, NYSE
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