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Portfolio protection utilizing stock index futures and options

Portfolio Protection Utilizing Stock Index Futures and Options

You’ve likely heard many of the potential dangers associated with the stock market: Volatile energy prices, tightening credit conditions, slowing economic growth, inflationary concerns, and the possibility of further Fed interest rate hikes in the coming months. As a prudent investor, how can you help protect the value of your stock portfolio during periods of uncertainty and heightened market volatility?

Many investors tend to cling to the belief that the only answer is diversification.

While it’s true that diversifiable risk typically declines rapidly as the size of a portfolio increases, it can never be entirely eliminated. More importantly, some events pose “systemic risks” and can have an impact across the entire market – a Federal Reserve monetary action or a significant geopolitical event, for instance. And finally, we’ve learned in recent years that correlations between global stock markets are perhaps much stronger than previously recognized – diversifying geographically may not always provide meaningful protection.

Introduction to stock index futures and options

One of the more effective – yet least understood – techniques for protecting the value of stock investments against systemic risk is hedging with index futures products. Holding an appropriate number of E-mini S&P 500, E-mini-Nasdaq 100, Mini-Russell 2000, or other stock index futures or options contracts can help insulate your portfolio value from market risk when the stock market tumbles – gains on your futures or options positions may to some extent offset losses suffered in your stock portfolio.

Strategy 1: Hedging with stock index futures

Want to get more complex? Precise hedge coverage requires a calculation of your portfolio beta – a statistical comparison of the portfolio’s changing value over time to the changes in the relevant index value (a portfolio beta of 1.0 indicates that over time the portfolio value has moved in the same proportion as the index, while a beta of .7, for instance, indicates that the portfolio value has moved only 70% as far, on average, for each index price change).

Continuing our example, suppose you compare your $3,000,000 portfolio statistically against the S&P 500 and calculate a portfolio beta of 1.2. To find the number of contracts for full coverage, divide your portfolio value by the current value of the S&P 500 Index, and multiply by the hedge ratio (beta).

Full coverage with futures would require the sale of 29 contracts. This would effectively neutralize the portfolio, so that you’d expect neither to gain nor lose materially on the overall stock/futures position. If you later decide to increase or decrease the size of your portfolio, simply recalculate the needed coverage and adjust your hedge accordingly.

Understand that hedging need not neutralize an entire portfolio – consider phasing in a futures or options hedge. You could immediately initiate, say, 50% of the number of contracts for a complete hedge. If your concern about the direction of the market proves correct and prices begin to decline, you may choose to increase your coverage, perhaps to 75% of the portfolio value. When you feel that the market is poised for a recovery, remove the hedge by phasing it out in a similar manner, or by offsetting the entire position. You can constantly make adjustments in this fashion, depending on how your market outlook changes.

Strategy 2: Protection against a falling market – buying put options on S&P 500 futures

If you have experience with equity options, you should have little difficulty transferring your knowledge to options on stock index futures. Like equity options, futures options allow investors with just about any time horizon and risk appetite to construct appropriate strategies.

In the earlier section on hedging with futures, we used an example of a $3,000,000 portfolio requiring the sale of roughly 29 futures contracts for protection against an adverse downward move. Another possible alternative is to hedge using options. By buying 29 put options, you could defend against a large decrease in the value of the portfolio, while still maintaining your profit potential if the market were to rise.

The purchase of puts as a hedge works just like insurance. You simply buy the number of puts dictated by the short futures hedge ratio calculation. The degree of coverage would be determined by the choice of the strike price. Higher strike puts would be more expensive than lower strike price puts, but the protective feature of higher strike puts becomes effective much sooner (much like a low insurance deductible means higher premiums, but coverage “kicks in” faster). The hedger is therefore faced with the decision of how much protection to take on, and at what cost.

Strategy 3: Generate additional income in a stable or declining market – writing call options

The seller of an E-mini S&P 500 call option receives payment (the premium) from the buyer of the option in return for the obligation of taking a short position in the futures contract at the exercise price if the option is exercised. The call writer’s risk is unlimited, while the call buyer’s risk is limited and the call writer’s profits are limited, while the call buyer’s profits are unlimited.

The principal reason to write call options is to earn the premium. In periods of stable or declining markets, call writing can mean an attractive cash flow from a relatively small capital investment. Many equity option traders are familiar with this strategy, which is often referred to as a “covered call” position. The hope is that, at expiration, the settlement price of the futures contract will be at or below the exercise price of the option. The option will then expire worthless – and you keep the entire premium.

The premium also gives limited protection against a drop in the futures price. The risk is that the futures price might decline by more than the premium received, and the investor may experience a net loss. Therefore, this is not as effective a hedge as the short futures or long put strategies. The attraction, however, is that, depending on the strike price of the sold calls, the trader may leave room for the underlying stocks to rise in value without incurring a loss on the hedge.

Strategy 4: Using collars to hedge your portfolio in a declining market

Collars – also commonly referred to as “fences” or “risk reversals" – combine out-of-the-money call writing with the purchase of put options with a lower exercise price. This strategy offers some downside protection, but also reduces some of the cost associated with purchasing puts as a hedge. The proceeds from the sale of the call option will help offset the cost incurred from buying the put, and the net out-of-pocket expense will be less than if the investor had bought put options only. In short, collars offer some degree of portfolio protection at a low cost in exchange for foregoing some of the profit potential from a market move to the upside.

Conclusion

Stock index futures and options offer investors numerous investing and trading opportunities – and in a declining or volatile stock market, they may be used as a hedging vehicle to help protect the value of your stock portfolio.

Although many investment professionals use complex hedging and arbitrage strategies, even individual investors can use stock index futures and options strategies to profit in challenging markets. This article presents just a few examples of strategies that may allow investors to insulate portfolios against general stock market declines.

Like any other investment, the ultimate decision of whether or how to incorporate stock index futures into your portfolio should be based upon your personal goals and risk tolerance. But it’s important to know that futures and options strategies like those described in this article are available to individual investors, and in fact, a growing number of brokers today allow these products to be traded alongside securities – on the same platform.

Best of all, now that you know a little bit more about hedging with futures and options, you can move beyond the often over-hyped concept of diversification and consider alternative methods of portfolio protection.

 

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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice.

Hedging and protective strategies generally involve additional costs and do not assure a profit or guarantee against loss.

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