Every investor has seen it happen: a carefully selected portfolio of profitable stocks getting hammered by the Fed, Congress, or some other market-wide calamity. Suddenly their net worth is less, not because they picked the wrong stock, but because they were in the market at the wrong time. Even more upsetting is the fact that they could see financial doom on the horizon. If only there was some way of getting in and out without paying the spread and brokerage fees, or better yet, eliminating the variability of the market as a whole, so a portfolio would change only because of the quality of the companies selected.
Luckily, institutional investors have developed a number of methods for hedging risks like the ones mentioned above. Hedging is protecting assets against loss by trading in separate instruments in a way that offsets those losses. One of the most effective hedging tools used by investors is futures; in the case of hedging equities, E-mini S&P 500 Futures. E-mini S&P 500 Futures allow any investor to hedge the risks of the overall market without compromising returns on a well-constructed portfolio.
And while you might have heard futures were complicated and risky, the riskiness of futures depends entirely upon how they are used. When used as a hedging tool, futures may actually decrease risk. Also, using futures can be simplified considerably with a little bit of guidance. Hedging equities with futures contracts, however, is likely new to most investors, so some background is in order. In particular, anyone contemplating using futures needs to understand how futures work and the risks of using them, how to calculate the risk in a portfolio, and how to calculate the optimal number of contracts with which to hedge.
Mechanics of Futures
Futures sound far more intimidating than they are in reality. A futures contract, at its most basic, is an agreement to pay or receive the difference between the price of some underlying item on trade date and some fixed date in the future. However, due to the facts that futures contracts are cleared through a clearing house, gains and losses on the futures contract are realized from day-to-day. If the futures contract loses value, the buyer, (long position) pays the seller (short position). If the futures contract gains value, the short position pays the long position. For instance, if the E-mini S&P 500 Futures contract is valued at 2,000 one day and then increases to 2,001 the next day, the short side of an E-mini S&P 500 Futures contract would pay the clearinghouse $50. The amount is $50 because, in the futures contract specifications, the contract is defined as $50 per index point by the CME. At the same time, the clearinghouse would pay $50 to the buyer of the contract, who is the long side of the trade. Since there is one and only one buyer for every sold contract, the dollars balance out.
The above example contains the basics of futures; however there are a few other aspects that need to be understood. The first is margins, otherwise known as performance bond. When an investor enters a futures position, it might be unclear how much money the investor needs to pay for the contract since the investor is responsible only for losses relative to the trade price and no one is certain what direction the market will move. Initially, brokers will ask their clients to put some money into an account, called initial margin, which is set by the exchanges, to cover any potential losses. Using the example above, if someone went long in an E-mini S&P 500 Futures contract, the broker might ask them to place $4,000 into an account. At the end of the day, the position would be “marked-to-market”, or adjusted to reflect the new market price, and $50 would be added to the account, so there would be $4,050 available.
Let’s say the investor had a bad week and the E-mini S&P 500 Futures contract loses 10 points for a loss of $500 (=10*$50). The investor’s account would now contain only $3,500 (=$4,000-$500). It would be likely the account would cross its minimum allowable balance, or “maintenance margin”. The investor would need to either add money to the account to account for the change in value called “variation margin” or the position would be closed out locking in the losses. Initial and maintenance margin levels are all set by the clearinghouse for brokers based on the volatility of the contract and other factors. A clearing broker has the ability to set these levels higher for their customers and many do so.
The second aspect to understand is that all futures contracts settle at some point. Due to the fact certain traders actually wanted physical commodity as part of their business operations, futures were originally based on physical commodities like wheat or cattle. At a predetermined time, futures contracts expire and settle requiring short positions to deliver the underlying commodity to the long position for the final futures settlement price. As the futures markets evolved, many financial futures, like the E-mini S&P 500 Futures contract, were developed whereby the contracts are cash settled. In a cash settled contract, open positions are extinguished at a price based on the settlement price of the underlying commodity or instrument on that day or at market opening on the following day.
The majority of positions are offset by trading out of the position well before expiration and final settlement of a contract. However, one should be aware that contracts are dated, so one must be careful not to enter a futures trade for a date shorter than one needs to hedge. Even if an investor ends up needing the position longer than the settlement date, or wants to hedge for a very long time, the contract can be “rolled” to a longer dated contract before settlement.
Exactly how does this help someone who owns a group of stocks on which they want to decrease their risk? They can simply short the E-mini S&P 500 Futures contract for as long as they want downside protection against the market. Losses in the stock positions due to general market movements will be compensated by gains in the short futures position. The natural question is, for a given portfolio, how many contracts should one purchase or sell to gain adequate protection? Answering this question requires a bit of work.
Real Hedging of Equities
In order to use futures to hedge we need to do a bit of very simple arithmetic. In order to understand that simple arithmetic we need much more complicated math which I will describe, but don’t feel like you need to understand it perfectly. How you use it will become clear in the example.
A mathematician, using a bit of calculus, can show that the optimal number of contracts is the value of the portfolio divided by the value of the futures contract times a factor called a “hedge ratio.” The hedge ratio arises when the hedge isn’t exactly the same as the underlying asset. If one were hedging with an index future constructed around our exact portfolio, a hedge ratio would not be needed. The hedge ratio is the ratio of the variance (similar to the volatility or risk) of the portfolio to the variance of the futures contract multiplied by the correlation between the two.
Since most investors aren’t mathematicians, I will assume that very little of what I just wrote made sense. However, the important part is that if an investor can figure out what to use as a hedge ratio, they could determine the optimal number of contracts to hedge an investment portfolio because the value of the portfolio and the value of the contract are known.
Calculating hedge ratios can be time-consuming, but fortunately, in the case of equities, a simple short-cut has been developed. The Capital Asset Pricing Model (CAPM) is a well-known method of determining the riskiness of a portfolio based on the variability of a stock’s return compared to the market as a whole. The riskiness of a portfolio in CAPM is called “beta” and it will stand in for our variances in the hedge ratio.
One of the nice parts of CAPM is that the riskiness of the asset or group of assets is compared to the market as a whole. This means that the riskiness of the market or its “beta” is always one. One can also confidently assume that the variance of the market and the futures contract are approximately identical because the futures contract is highly correlated to the S&P 500 Index, the most recognized measure of broad market risk in the U.S. This eliminates a need for a separate variance and correlation for the futures market.
In order to hedge with equity index futures, the beta of the asset or group of assets is the last quantity we need to determine. To find the beta of a portfolio, one can compute a linear regression of portfolio returns as compared to the market as a whole (which has advantages) or simply take a weighted average of individual stock betas. Since beta is such a popular measure of risk they can be gathered right off the internet or provided by a trading system as well. Once we have the beta of our portfolio it can be substituted directly for the hedge ratio in our calculation.
While this theory is interesting (or maybe not), a concrete example will make the process clear. Let’s say an investor had a simple portfolio of three stocks (most portfolios probably have more stock symbols but extending this example is very straightforward.) The investor has 1,000 shares of Procter and Gamble (NYSE:PG, $76.02, beta=0.37), 2,000 shares of Exxon-Mobil (NYSE:XOM, $86.32, beta=0.89), and 3,000 shares of Cisco Systems (Nasdaq GS:CSCO, $22.69, beta=1.38). The value of the portfolio is $316,730.00 (=1,000*$76.02+2,000*$86.32+3,000*$22.69) and the weighted average beta which is going to stand in for our hedge ratio is 1.05 (=(1,000*0.37+2,000*0.89+3,000*1.38)/6,000).
All that is needed now is information on E-mini S&P 500 Futures contract. Let’s say the investor in this example wanted to hedge for the next month because that will be a long enough time for a predicted market instability to materialize or dissipate. Assume the December E-mini S&P 500 contract has a price of 1,673.75 with a contract size of $50 per index point. A single contract is then worth $83,687.50 (=1,673.75*$50). Taking the value of the portfolio ($316,730.00), dividing it by the value of the futures contract ($83,687.50), and multiplying the result by our hedge ratio (1.05) the optimal hedge for the portfolio would be to short 4 contracts ( ($316,730.00/$83,687.50)*1.05=3.97).
Performance of a Portfolio Using a Futures Contract as a Hedge
Let’s see what this means in terms of the financial performance of the portfolio over time. For example, let’s say the futures contract moves to 1,690.50 at the end of the month so our futures position loses $837.50 (=$50*1,673.75-$50*1690.50) times 4 since we covered, or bought back, 4 contracts for a total loss of $3,350.00. Our equity position moves to $323,856.43 for a gain of $7,162.43 (=$323,856.43 - $316,730.00) and a net gain of $3,812.43. One may at this point feel upset about not getting the full $7,162.43 from the gain in stock prices; however, remember that the point of hedging is to mitigate the possibility of massive losses, so there is some upside cost.
One might feel better considering a very different position after a month. If the portfolio has a substantial loss because one’s intuition about the market turns out correct and the portfolio goes down to $304,852.63 while the futures position moves to 1,623.50, the loss due to the stock position is $11,877.38, but there is a gain of $10,050.00 on the futures position for a net loss of only $1,827.38. Our hedge, in this case, really paid off.
Other options are also possible. Both positions can lose if our analysis on the market and the stocks is flawed. Both positions can win as well if our analysis of the market is wrong but the equity analysis is correct. Most equities tend to move in similar direction with the overall market implying that it is more common to lose on one position while gaining on another.
Futures: A Powerful Tool in the Right Hands
Futures are not a tool for every investor. They are right for people who do their homework and are good at analyzing both stocks and the overall market, as well as seeing the need from time to time to hedge risks. While a properly executed futures hedge reduces risk, futures require some knowledge and discipline in their use.
If one has all of those tools in place, the power of futures to manage market risks is remarkable. Using a commonly available risk metric called beta, we have seen how we can calculate the right number of contracts to hedge a basic portfolio and analyzed some possible outcomes. Even if an investor decides not to use futures in their set of financial tools, at least one can appreciate the methods and outcomes of funds which do.