The stock market has been volatile and uncertain since the beginning of 2022, and you may have stocks in your portfolio not making money. The question is, “What can you do if you want to keep these stocks?”
In my previous article, I shared with you how to use Options to enhance your stock portfolio returns. Today, I will explain how you can hedge your stock portfolio risks using a “futures contract”. This is a strategy often deployed by institutional managers and professional investors.
It sounds difficult to implement, but it is readily available to retail investors like yourself.
Futures is another form of “derivative”. They are financial contracts based on the value of an underlying asset or benchmark. These underlying assets can be stocks, bonds, commodities, currencies, interest rates, market indexes or even cryptocurrencies.
While futures can be complicated, you don’t have to know everything to take advantage of them. A simple future hedging strategy can be very useful to most retail investors.
In this article, I will explain 3 things:
- What are futures contracts?
- How to use futures to hedge portfolio risks.
- A real case study and what you should be aware of.
Note: Let me put a disclaimer up front: This article and any examples used are for educational purposes only. It is NOT financial advice. As the article is meant for beginner investors, I will simplify some technical details and concepts. If you feel lost by reading the article, it is ok. It simply means you should spend more effort studying the instruments before jumping into them.
Let’s dive in…
What are Futures Contracts?
A futures contract is an agreement between two parties (buyer and seller) to buy or sell a specific underlying asset at a preset price at a future date. We will just call futures contracts “futures” in this article. Futures are traded on futures exchanges such as the CME Group and Singapore Exchange (SGX). If you are new to futures, there are three things you need to take note of:
- Futures have an expiry date (the future date) – This means you cannot hold the position indefinitely. So, it is mostly suitable for short-term trading or positioning.
- You can buy or sell futures – This means you can take a long position to profit from an asset price rising or take a short position to profit from an asset price falling.
- You are trading on margin, so be extremely careful – I hope the word “contract” scares you and you take this seriously.
How to use Futures to hedge portfolio risks?
Let’s assume you have a portfolio of US stocks. You think these are solid stocks and their share prices should rise in the long run. You want to keep those stocks but you are worried about the looming recessions and that the market may crash. After all, the most painful thing is to sell your stocks, only to see the market rally from that day onwards.
What you can do?
One option is to short S&P 500 futures to limit your exposure.
What this means is that if the US stock index S&P 500 falls in value, you can make a profit and this will neutralize the collective loss that you incur in your stocks.
Of course, if the S&P 500 index goes up, you will lose money in your futures position, but you will likely gain in your overall stock portfolio.
I won’t discuss whether you should make a full hedge or partial hedge, nor when to close the position. This is quite complex and beyond the scope of this article. You can google and study more.
I will use the Tiger Brokers platform to demonstrate how to use futures. The Tiger Brokers platform is quite useful because it has all the instruments under one platform.
To find S&P 500 futures, go to Market, click on “Futures”, and you will see the “E-mini S&P 500” instrument. Remember futures have expiry days, right? This contract “2209” is the nearest one which is expiring on September 22.
The reason it is called E-mini is that it has a smaller contract size. The original S&P 500 futures contract is designed for institutions and the exposure is often too big for retail investors.
You can check out the CME website for the S&P 500 E-mini contract specifications.
For the E-mini S&P 500 contract, every 1 index point movement is equivalent to US$50 profit or loss in your position. In other words, when you short an E-mini futures contract, you will lose $50 for every point the S&P 500 rises and gain $50 for every point the S&P 500 falls.
Let me put the numbers into context.
Scenario 1: the S&P 500 index drops
Suppose you have a portfolio of US stocks worth about US$200K. Let’s say the S&P 500 index is at 4,300 and the market dropped about 7% to 4,000.
Maybe your stocks dropped 5% collectively and you lost US$10,000 from your stock portfolio. But because you shorted one e-mini S&P 500 futures, you will make US$15,000 profit from your futures position. So, your net profit is still US$5,000.
At this moment, you can choose to close your futures position and take the profits. Sounds cool, right?
Scenario 2: the S&P 500 index rises
What if the US market rallies and rises 300 points? In this scenario, you may lose US$15,000 from the futures position but maybe your stocks gained 5% and you made US$10,000.
You suffer a net loss of US$5,000, even if the market goes up.
Then your question must be: “Isn’t it better if I didn’t short the futures contract in the first place?”
The answer is simple: nobody has a crystal ball!
If you are a prophet, you would have already become rich and you don’t need to read this. The reason that we are going through all this trouble is that we want to “hedge” our position to “protect” and reduce the volatilities of our portfolio.
Don’t start trading futures if you don’t understand the margin requirement
When you learn about futures, it is of paramount importance to understand margin. Many people, even professionals, lost fortunes when they didn’t pay attention to the margin requirements.
The futures margin is the amount of money that you must deposit and keep on hand with your broker when you open a futures position.
Why do traders like this?
Loosely speaking, margin is like the down payment you pay for your house. It is typically a percentage of the total contract value. The beauty of margin compared to a loan is that you do not need to pay interest for the money you “borrowed”.
The margin is your money at risk in a day, not your total risk exposure!
The initial margin is often how much you may lose in a single day statistically. So never think that you just need to deposit the margin to your trading account and you are done. When you are on the wrong side of the market, you need to keep on topping up cash to cover the margin.
So, what is your risk exposure?
It is the real value of one E-mini S&P 500 contract.
Remember just now we said 1 index point movement is equivalent to US$50. Based on 4304.50 S&P 500 Index Level as of August 16 closing, one E-mini futures contract costs about $50 * 4304.50 = $215,225.
But to enter this contract, your initial margin is only US$11,000. See the difference?
How to check the margin requirement?
Under the Tiger Brokers desktop platform, you can click on the “Contract” next to the name of the futures contract.
You will see the “initial margin” and “maintenance margin”. Do note the broker will likely increase the margin requirement in a volatile market, so you need to make sure you have a sufficient cash buffer in the account before you place the trade.
Leverage is a double-edged sword, it frees up liquidity so you can free up the cash to trade other securities, but it can also backfire if you don’t know what you are doing.
I cannot emphasize this more: do your sums right and deposit an ample cash buffer before you place any trade.
Choose an all-in-one platform for trading.
In this article, I have used Tiger Brokers to demonstrate the strategy because they allow you to trade stocks, options and futures under the same platform.
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Let me summarize…
To recap, if you have a large-size stock portfolio and you believe the market may take a fall in the near term, you don’t have to sell your positions right away.
One strategy you can adopt is to short a futures contract for the index and hedge your portfolio risks.
Just to add on, you can even use non-stock futures to hedge stock portfolios.
For example, when the Russia-Ukraine war just started, long Gold futures worked well as it was hard to sell stocks at a good price in such a volatile period. Look at the chart below.
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