How do I manage risk in my portfolio using futures?

E*TRADE Futures

06/07/19

As we all know, financial markets can be volatile. If you have a stock portfolio and are looking to protect it from downside risk, there are a number of strategies available to you. But here’s one you may not have considered: Hedging your risk with equity index futures.

Many investors are told that futures are complex—and they are. But building a futures hedging strategy can be completed in just three steps, making it easy to manage risk effectively. Plus, hedging with futures is possible in both brokerage and retirement futures accounts.

Here’s how to hedge a stock portfolio with equity index futures:

1. Identify the equity index futures product you'd like to use as your hedge.

The futures you use to hedge your stocks should generally match up with the type of portfolio you have. Here are some examples.

  • For a broad-based stock portfolio: The CME E-mini S&P 500 and CME E-mini Dow represent different cross-sections of the broad US market.
  • For a technology-heavy portfolio: The CME E-mini Nasdaq has a large representation in high-tech industries, including cloud computing, networking, software-as-a-service, and more.
  • For a small-cap portfolio: The CME E-mini Russell 2000 represents holdings in thousands of faster-growing, small-capitalization US companies.

2. Calculate how many futures contracts you need.

To do this, divide the total value of your stock portfolio—say, $280,000—by the notional value of the equity index futures product you’ve chosen.

You can look up a future’s notional value online. But you can also calculate it by multiplying the current value of the underlying index by the future’s contract size.

For example, say you’ve chosen the CME E-mini S&P 500 as your hedge. If the underlying index, the S&P 500®, is trading at 2,800, and the contract size of the CME E-mini S&P 500 is $50, then the notional value of the CME E-mini S&P 500 is $140,000 (2,800 x $50).

In this scenario, how many contracts would be needed to hedge the stock portfolio?

The answer: Two. That’s $280,000 (the portfolio’s total value) divided by $140,000, the notional value of the CME E-mini S&P 500.

3. Establish your hedge by selling the futures contracts.

By selling the contracts, you're essentially assuming that the direction of the underlying index will change.

This means that, if the market goes down, the amount you lose from your stocks would be generally offset by gains in the short futures position. The likely net effect is little change in the value of your portfolio, even in the event of a steep market decline.

Of course, the same is true in the opposite direction: the futures loss would roughly cancel out any gains the stocks might generate in a market surge.

Keep in mind, though, that this is only an approximate hedge. It’s not perfect. The offset amount of the gains (or losses) from the hedge will depend on how correlated your stock portfolio is to the futures index you choose.

When you’re ready to reverse your hedge and reassume full risk, just close your futures position by buying back the contracts you sold.

In closing, equity index futures can be a powerful new tool in your investing toolkit.

They give you the opportunity to manage risk across your holdings—without a high initial capital commitment or the need to disrupt your underlying portfolio. Using equity index futures is easy, efficient, and affordable.

 

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