A futures contract is an agreement to buy or sell a predetermined amount of a commodity or financial product on a specified future date. Futures are traded on exchanges and span a variety of asset classes: stock market indexes, interest rates, currencies, and commodities like crude oil or gold.
Professional investors and traders can use futures to hedge1 against potential market downturns as an investment strategy. For example, they may attempt to protect or insulate their portfolios against "black swan" events, such as a financial crisis, an unexpected election outcome, or market crash.
Individual investors might also use futures contracts linked to the S&P 500® index (SPX), Nasdaq-100®, or other equity benchmarks to hedge their portfolios against market volatility and slumps.
While futures can provide a potential hedge for some situations, they also carry risks like potentially reducing the overall increase of your portfolio value or creating significant potential loss. Futures can work for some investors and traders depending on their risk tolerance, but trading the futures market is not for everyone, and not every account qualifies for futures trading.
Hedging against a global event risk
Some stocks might seem like good investments over the long term, but current events and market conditions can still lead to short-term losses. A futures-based hedging strategy offers the potential for investors to weather unforeseen events without having to part with shares they already hold.
Futures are typically highly leveraged, meaning that by putting a relatively small amount of money down, investors can establish positions in a relatively large amount of underlying value—often referred to as "notional" value. Because of this leverage, an investor can use a smaller amount of initial capital to hedge a large portfolio. However, that leverage can potentially magnify losses as well as enhance potential gains. So, a small amount of market movement can have a large effect—positive or negative—on an account's profit and loss.2
Futures trading is also available nearly 24 hours a day, five days a week, offering an investor the ability to hedge their portfolio almost around the clock. Some investors find this valuable because events that occur outside U.S. equity market hours can affect the 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 applying beta weighting, the process of comparing the volatility of a stock and an index. Beta measures the theoretical volatility of an individual asset or an entire portfolio in comparison to a benchmark, such as the SPX.
Applying beta weighting to hedging is usually an attempt to reduce your portfolio's delta. Delta is the approximation of the change in the price of a derivative relative to a change in the price of the underlying stock, with all other factors held constant. If a portfolio has positive delta, but the trader thinks the market might drop, they might consider reducing their delta exposure. One way to do this is by adding a position with negative delta like a short E-mini S&P 500 futures (/ES) contract.
If a trader knows how many positive deltas are in their overall portfolio and how many negative deltas a short /ES futures contract has, it's possible to determine how many futures contracts to sell to hedge their portfolio.
For example, if a portfolio has 447 deltas, one /ES futures contract would add negative 50 deltas. Based on these numbers, if the SPX fell one point theoretically, 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 it's possible to see the potential risk associated with each position expressed in the same unit. A bullish trader would want to see more positive deltas, while a bearish trader would want fewer positive, or even negative, deltas. This approach focuses on looking at how a portfolio might respond to an increase or decrease in the overall stock market.
Futures-based hedge example
Let's suppose an investor has a $925,000 stock portfolio that mostly aligns with the SPX. They're concerned about an upcoming economic report that could cause their portfolio to drop in value. They're considering hedging about 30% of that portfolio by selling (or shorting) one / ES futures contract. The /ES is currently trading at 4870 and has an initial margin requirement of $19,000.
In order to determine the total amount of margin required, they must calculate how many contracts to short. They can do this by comparing the percentage of the portfolio to be hedged with the notional value of one contract. Hedging 30% of the portfolio means the hedge should have a notional value of $277,500 (925000 X 0.30). To calculate the notional value of the /ES, they'll multiply the price of the contract to its multiplier of $50. Therefore, an /ES contract has a notional value of $243,500 (4870 X 50). This means that they can short one contract. It won't be the entire 30% they had hoped for, but two contracts would be nearly half the value of the portfolio, which would be a big hedge but also a big risk to the portfolio if the SPX rises instead of falls.
So, with one contract, they'll put up the initial margin, which in this example is $19,000.
Let's talk about how the hedge works. If the SPX dropped and the /ES contract fell 50 points (about 1%), the investor might then consider buying back, or "closing out," that futures position to realize a gain of $2,500. That gain could help offset any unrealized losses in the stock portfolio. By taking a position in the futures contract, an investor gains similar notional exposure while tying up a lot less capital. However, this isn't always the outcome: It is possible that a hedge can limit the potential gain the portfolio may have recognized if the hedge was not put on.
Long or short, futures trading can be a useful tool for hedging a portfolio. Keep in mind that short positions create unlimited risk as there is no limit to how high the price of the shorted position may go; in other words, if an investor has to buy to close that position, there is no limit to how much they may have to spend to close the short position. However, with an appropriately hedged investment strategy, some of that risk might also be offset by the rise in the portfolio's long positions.
1 Taking a position in an attempt to offset the risk of another position in stock or options.
2 Profit and loss of the aggregate total of all gains and losses over a specific period of time (e.g., day, month, year). Often confused with ROI, which is just the return on investment of a single trade or position.
