Upbeat music plays throughout.
Narrator: Many investors manage their portfolios using notional value because it's easy to understand the cash value of their positions.
On-screen text: Equation: Portfolio value of $500,000 multiplied by percentage you want to hedge of 30% equals size of hedge of $150,000. New equation: Size of hedge of $150,000 divided by futures notional value of $135,000 equals number of contracts needed or one.
Narrator: For example, if your portfolio is worth $500,000 and you want to hedge 30% of it using equity index futures, it may be easier to calculate how many contracts you'd need using notional value.
Animation: A graph compares technology and utility stocks showing technology stock to be more volatile.
Narrator: However, notional value doesn't account for how various types of positions in your portfolio may respond to market movement differently. For example, if you have the same amount of money invested in technology stocks as you have in utility stocks, you could have similar notional values. Technology stocks tend to be much more volatile than utility stocks, so you would need a technique that allows you to measure the potential differences. The problem with using notional value is that it treats all assets the same.
This can make hedging difficult because it's hard to know how much protection you need if you don't know how much risk you're carrying.
One alternative to using notional value is a technique called beta weighting. Beta represents how volatile one asset is compared to another. Beta weighting is a way to measure your portfolio's theoretical risk relative to a single asset or index—like comparing apples to apples.
So, for example, if you want to hedge your portfolio with the E-mini S&P 500, you can beta weight your portfolio to the ES and see all your positions' risk relative to the movement of the S&P 500®. This can make it easier to determine how your portfolio might respond to a downswing. Determining how much to hedge based on potential risk exposure rather than just notional value may help you to more precisely calculate how much protection you might need.
Now let's look at how beta weighting works and how to use it on thinkorswim® paperMoney®. You can find the beta-weighting tool in the Position Statement section on the Monitor tab. To activate it, I'll select the Beta Weighting box.
Next, I'll enter the instrument I want to use as my benchmark. For this example, we'll assume our portfolio generally tracks the S&P 500 and that we'd want to use the E-mini S&P 500 futures contract to hedge, so I'll enter slash ES.
To see the results, you'll need to have a Delta column in your Position Statement. If you don't, it's easy to add one using the gear icon.
On-screen text: Mouse clicks on the gear icon, then selects Delta in the available items column. Add item(s) is clicked, and then OK is selected, closing the menu box.
Narrator: When you're beta weighting, delta indicates how much you stand to gain or lose, all else being equal, if your selected benchmark changes one point. Basically, it's a measure of risk exposure. If you're bullish, you'll want to see more positive deltas. If you're bearish, you'll want fewer positive, or even negative, deltas.
Now, on the Position Statement, each security has a delta. If a position has positive deltas, it'll gain value if the benchmark goes up and lose value if the benchmark goes down. Positions with negative delta will do the opposite—drop when the benchmark rises, and rise when the benchmark falls.
This is one of the main benefits of beta weighting. You can see the potential risk associated with each of your positions expressed in the same unit.
Here, you can see the total delta for the whole portfolio. This sample portfolio has a delta of 447, which means the portfolio is estimated to rise about $447 for every point our benchmark, the ES, rises.
It also estimates that the portfolio will fall $447 per point the benchmark falls.
So, how can we apply this to hedging a portfolio?
When beta weighting, think of hedging as an attempt to reduce your portfolio's delta. 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, for example, a short index futures contract.
On-screen text: Portfolio delta multiplied by percentage you want to hedge equals hedge delta. Hedge delta divided by futures contract delta equals number of contracts.
Narrator: If you know how many positive deltas your overall portfolio has and how many negative deltas a short futures contract has, you can determine how many contracts to consider selling to hedge your portfolio. Let's walk through this calculation with our sample portfolio.
On-screen text: Portfolio delta of 447 multiplied by hedge percent of 30% equals hedge delta of 134. Hedge delta divided by futures contract delta of -50 equals number of contract of 2.
Narrator: We can see here that our portfolio has 447 deltas. So if I wanted to hedge my portfolio, 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 be expected to fall an estimated $447. However, the portfolio with the hedge would theoretically only fall $396.
Of course, beta weighting doesn't stop the risk of timing the market that comes with hedging. You still have to determine when to close the hedge to avoid the drag that the contract causes. Remember, having higher deltas when the market turns bearish could also result in higher losses. Whereas, lower deltas when the market turns bullish could reduce your gains. So, follow your investing plan to know when to open your hedge and when to close it.
You can see that beta weighting on thinkorswim paperMoney can be a valuable tool for determining how much to hedge your portfolio. Measuring your portfolio in terms of market exposure may help you hedge more effectively.
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