How Hedging Can Reduce Portfolio Risk

Upbeat music plays throughout.

Narrator: Being invested in stocks during a downswing can feel like driving down a steep hill. Similar to how some drivers ride the brakes in order to avoid losing control, some investors may sell their positions to try to limit losses. However, just like riding the brakes can damage your car, selling stocks can lead to transaction and opportunity costs that can ultimately damage your returns.

Instead, experienced drivers shift into a lower gear that allows the transmission, instead of the brakes, to slow the car. Experienced investors can do something similar by hedging a stock portfolio with futures.

You can think of it like shifting your portfolio into lower gear to help slow the fall. There are a number of factors that can impact the effectiveness of a hedge and, like any investment strategy, it isn't guaranteed to work. But if applied carefully, a hedge could help offset some losses when markets fall. Let's discuss how you can design a hedge that aims to reduce risk in a portfolio and examine a few risks that come with hedging with futures.

Imagine this line represents your portfolio's performance over time. The value of the portfolio rises and falls as the underlying assets rise and fall. Depending on the type of investments, these swings can be quite large.

Hedging aims to reduce the downswings without reducing the upswings.

The idea is that before a downswing you enter a position that moves in the opposite direction as your portfolio. As your portfolio drops in value, the expectation is the hedge rises in value, potentially offsetting some losses. Then, when the portfolio starts to recover, you close the hedge and allow the portfolio to grow.

Of course, hedging isn't that simple. First, timing the market is difficult. Hedging too soon or too late can cut into your overall returns.

Think of our car example. Hedging your portfolio during an upswing is like getting to the bottom of the hill and forgetting to shift back to a higher gear. The lower gear slowed your speed on the way down—now it's slowing your acceleration.

Additionally, it can be difficult to find a hedge that perfectly matches your portfolio. Depending on the makeup of your portfolio and the instrument you use, the hedge may not work as intended, leading to potential large losses if both your portfolio and the hedge lose value. The risk to the short hedging position is theoretically unlimited since there is no limit to how much the underlying index could rise.

Hedging also incurs commissions and fees, which also affect your overall returns.

We've visualized hedging as a car in a lower gear, but how does hedging look in your account? Let's look at the numbers. 

Animation: Portfolio drops from $600,000 to $576,000.

Narrator: Say we have a portfolio of $600,000 that largely tracks the S&P 500^®. In this example, let's say the S&P 500 fell 60 points, which equates to a potential loss of about $24,000.

However, by shorting an E-mini S&P 500 equity futures contract, we could potentially offset some of those losses. To calculate how much, we need to look at the futures contract's notional value.

The notional value of a futures contract is the futures price multiplied by the contract multiplier. If we assume the E-mini S&P 500 equity futures contract is trading at $2,700 and the multiplier is $50, it has a notional value of $135,000.

Animation: Portfolio drops from $600,000 to $576,000. E-mini S&P 500 futures contract gains $3,000.

Narrator: So, the 60-point drop in the S&P 500 that caused the rest of the portfolio to lose value would mean a gain of $3,000 for the short futures position.

Animation: Portfolio increases from $576,000 to $579,000.

Narrator: The $3,000 gain offsets some of the losses in the rest of the portfolio, resulting in a total loss of $21,000 instead of $24,000. This translates into a loss of 3.5% instead of 4%, or a 12.5% reduction in losses, not including commissions and fees.

So, the hedge slowed the decline. At this point, if we thought the market was going to rally, we'd want to make sure we removed the hedge, so it doesn't drag on our portfolio or lead to large and potentially unlimited losses during the recovery.

You see how hedging reduces risk by potentially reducing losses. If the market turns down, you may not have to burn out your brakes; hedging is one way to potentially "gear down" in an attempt to protect your portfolio.

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