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Portfolio Risk Management with Futures and Options

Various macroeconomic risks can affect the stock market—volatile energy prices, tightening credit conditions, slowing economic growth, and inflationary concerns can all take their toll. 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 assume diversification is their only option for managing portfolio risk. And while it’s true that diversifiable risk typically declines rapidly as the size of a portfolio increases, it can never be entirely eliminated. The problem is that some events pose “systemic risks” and can have an impact across the entire marketa Federal Reserve monetary action or a significant geopolitical event, for instance. We’ve also learned in recent years that correlations between global stock markets are perhaps much stronger than previously recognizedso diversifying geographically may not always provide meaningful protection.

Fortunately, other strategies are available.

Portfolio hedging strategies - using index futures and options to manage risk

One of the more effective yet least understood techniques for stock portfolio risk management is hedging with index futures products. Holding an appropriate number of E-mini/Micro E-mini futures, or other stock index futures or options contracts, can help insulate your portfolio value from market risk when the stock market tumbles. How? In short, gains on your futures or options positions may, to some extent, offset losses suffered in your stock portfolio.

Strategy 1: Hedging risk with stock index futures 

Precise hedge coverage requires a calculation of your portfolio betaa statistical comparison of your portfolio’s changing value over time to the changes in the relevant index value. You can then use this calculation to determine how many futures contracts you should sell to completely cover your portfolio.

What might this look like? First, calculate the beta. A portfolio beta of 1.0 indicates that over time, movements in your portfolio value have been exactly proportional to those in the index. A beta of .7, on the other hand, indicates that your portfolio’s value has moved only 70% as far, on average, for each index price change.

So, suppose you compared your $3,000,000 portfolio against the S&P 500® Index and calculated 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).

Approximate full coverage with futures would require the sale of 20 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 decided to increase or decrease the size of your portfolio, or should your portfolio’s beta begin to change, recalculate the needed coverage and adjust your hedge accordingly, keeping in mind that unless your portfolio consists of the exact components in the exact ratios held in an index, you can only approximate a hedge.  

Portfolio hedge example described in text

Understand that hedging need not neutralize an entire portfolio. Instead, you could consider phasing in a futures hedge. You could sell, say, half the number of contracts you would need 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.  Note, however, that such adjustments will result in increased transaction costs. 

Strategy 2: Managing risk in a falling market – buying put options on E-mini 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 tolerance to construct appropriate risk-management strategies.

In strategy 1 (hedging risk with stock index futures), we used an example of a $3,000,000 portfolio requiring the sale of roughly 20 futures contracts for protection against an adverse downward move. Another possible alternative is to hedge using options. By buying 20 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 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. 

$3,000,000 stock portfolio to hedge

Dec E-mini S&P index futures are trading at 2980.00

November 2950 put is trading around 15.00 points ($750 each)

Solution is to buy 20 of the November 2950 put options for 15.00 point each

Downside Breakeven Point = 2935.00

(Strike – Premium Paid = 2950 – 15.00 = 2935.00)

Potential Profit = Virtually unlimited profit potential on the puts you’ve purchased, which is designed to offset the falling value of your stock portfolio

Maximum Risk = Limited to the premium paid (15.00 points per option)

Strategy 3: Generating 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.

$3,000,000 stock portfolio to hedge

Dec E-mini S&P index futures are trading at 2980

November 2950 put is trading around 15.00 points ($750 each)

November 3010 call is trading around 16.00 points ($800 each)

Solution is to buy 20 of the November 2950 put options for 15.00 points each, and sell 20 of the November 3010 calls at 16.00 point each

Net cash credit per spread is 1.00, or $50. For the entire position, therefore, the trader receives a cash credit of $1,000

Upside Breakeven Point = strike price of call + net cash credit = 3010 + 1.00 = 3011.00. The portfolio will forego all gains above 3011.00

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

Collarsalso commonly referred to as “fences” or “risk reversals"combine out of the money (OTM) call writing with the purchase of put options at 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 all profit potential from a market move to the upside above the strike price of the call.

$3,000,000 stock portfolio to hedge

Dec E-mini S&P index futures are trading at 2980

November 2950 put is trading around 15.00 points ($750 each)

November 3010 call is trading around 16.00 points ($800 each)

Solution is to buy 20 of the November 2950 put options for 15.00 point each, and sell 29 of the November 3010 calls at 16.00 point each

Net cash credit per spread is 1.00, or $50. For the entire position, therefore, the trader receives a cash credit of $1.00

Upside Breakeven Point + strike price of call + net cash credit = 3010.00 + 1.00 = 3011. The portfolio will forego all gains above 3011.00

Minimum Selling Price = strike price of put + net cash credit = 2950.00 + 1.00 = 2951.00

You don’t have to be an investment professional to use these strategies  

Stock index futures and options offer investors numerous investing and trading opportunitiesand 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 strategies, even individual investors can use stock index futures and options strategies to seek profit in challenging markets. Discussed here are 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 here are available to individual investors, and in fact, a growing number of brokers today allow these products to be traded alongside securitieson 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 over-hyped concept of diversification and consider alternative methods of portfolio risk management.

What You Can Do Next

  • Learn more about futures trading at Schwab.

  • Call 877-807-9240 to speak with a Schwab futures trading specialists.

  • Ready to get started? Enroll in Schwab Trading Services.

Important Disclosures:

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

Futures trading carries a high level of risk and is not suitable for all investors. Certain requirements must be met to trade futures. Please read the Risk Disclosure Statement for Futures and Options before considering any futures transactions.  Futures accounts are not protected by SIPC. For additional information on account protection at Schwab, please click here.

Commissions, taxes and transaction costs are not included in this discussion, but can affect final outcome and should be considered. Please contact a tax advisor for the tax implications involved in these strategies.

Past performance is no indication (or "guarantee") of future results.

The information presented does not consider your particular investment objectives or financial situation, and does not make personalized recommendations. Any opinions expressed herein are subject to change without notice. Supporting documentation for any claims or statistical information is available upon request.

The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. Examples are not intended to be reflective of results you can expect to achieve.


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