Hedging a stock portfolio can be a great way to preserve dividend income while minimizing losses from a downturn in the market.
In this post, you’ll get the 7 steps to hedge stocks with futures, including how much of your stocks you should hedge, how to pick the right contracts, how to assess the market direction and time frame, and rolling futures contracts.
I first began trading futures professionally to hedge huge oil contracts well over 3 decades ago. Now, through my trading club and programs, over the past 8 years, I have taught thousands of traders how to use futures for hedging.
Here are the 7 factors to hedging a stock portfolio using futures contracts.
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1. How Much of Your Stock Portfolio Should You Hedge?
If you correctly hedge 100% of your stock portfolio, you will receive a 0% gain if the market goes up. You’ll also receive 0% losses if it goes down.
If you only want dividend income, this might work out for you. But many investors do want at least some gain if the price of stocks goes up since, over time, stocks rise more than they fall.
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Therefore, the first thing you have to figure out is how much of your stock portfolio you should hedge.
Clarify Your Hedging Comfort Zone
Some investors may want to hedge 75% of their portfolio. This will allow them to get 25% of the gain from a rise in the market but only lose 25% if it goes down, for example.
Others may be comfortable only hedging 50% of a portfolio. Hedging is a constant trade-off between risk and reward.
Market Cycles and Hedging Stocks
Another factor that will influence how much of your stock portfolio you’ll want to hedge is the clarity of the market cycle. If the stock market is in year 10 of a strong bull market, the yield curve is inverted, valuations are high, and the economy is slowing, you may want to hedge more of your stocks than if these only 1 or 2 of these bear market signs are present.
Stocks as a Percent of Net Worth
A stock investor with 80% of their net worth in stocks may want to hedge their stock portfolio more than someone with only 30% of their net worth in stocks.
The larger the percentage of net worth that is invested in stocks, the greater the number of protection investors want from hedging.
It all depends on the particular investor’s risk preferences. You have to decide what is the best percentage of your portfolio to hedge based on your own situation.
2. Pick the Right Futures Contract for Hedging Stocks
Once you know how much of your stocks to hedge, you need to pick the right futures contract to hedge with.
How to Hedge a Single Stock with Futures
If you only want to hedge a single stock, you can use a single-stock future to offset whatever declines may occur. For example, if you own Apple stock and are concerned that its price may decline, you can use AAPL1DU9 to hedge it.
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Then keep reading to learn how to hedge stocks with futures.
Hedging a Stock Portfolio with Index Futures
Hedging an entire portfolio with a single-stock future can get complicated. This is where an index future comes in.
An index future, such as the S&P 500 E-Mini (abbreviated “ES”), protects an investor from declines in an entire index. So if you have a diversified portfolio made up of mostly of stocks in the S&P 500 index, and if the stocks of that portfolio have exactly the same weights as the index, you can use the S&P 500 E-Mini to hedge your entire portfolio.
In reality, a diversified portfolio will not have the same stocks in the same allocation as an index. If this were the case, an investor would probably just buy an S&P 500 ETF.
This means that if your portfolio does not have exactly the same weights as the index, the index future will be an imperfect hedge. In this case, a 75% hedge will not exactly offset 75% of the losses from a market decline.
Depending on your investing strategy, this may be good or bad. Some investors want to shield themselves from a downturn in the overall market, but still want to benefit from gains in their individual stock-picking.
If so, hedging with an index future may be the right approach, even if the investor’s portfolio is not exactly like the index being hedged.
Imperfect hedging may be better than not protecting your stocks at all.
3.How to Calculate the Value of a Futures Contract
The third step in this process is to calculate the value of a futures contract.
Each futures contract is valued at a multiple of the underlying stock or index (ETF) it represents.
For example, the S&P 500 E-mini is valued at $50 times the points on the index. So if the S&P 500 is at 2,870, one contract of the E-Mini costs $143,500.
4. How to Calculate the Number of Futures Contracts Needed to Hedge
Once you’ve decided how much of your stock portfolio you want to hedge, picked the futures contract to use for hedging, and calculated the value of a single futures contract, you can calculate the number of contracts you need to sell short in order to hedge the desired portion of your stock portfolio.
Here’s how to do that: Take the value of the portion of your stock portfolio you want to hedge and divide it by the price of a futures contract.
For example, let’s say you want to hedge $430,500 worth of your portfolio.
And let’s say the price of a contract is $143,500. You need to write/sell $430,500 ÷ $143,500 = 3 contracts to correctly hedge this amount of your stocks.
5. Evaluate Stock Market Direction and Time Frame
The next step is to get a good idea of where the market is headed and over what time frame. Having this, you’ll be able to choose the right time frame for your options contract.
The next step, choosing a duration for your futures contract can be the hardest part of hedging stocks with futures, but using the following stock analysis tools will help predict market direction and when.
Using Charts to Predict Stock Market Direction
Using technical analysis on stock charts is priceless for guiding you to the best time frame for a futures contract. This is because charts provide an easy visual tool for spotting overall market trends.
You’ll want to check for area listed below.
- Major support and resistance
- Key moving averages
- Fibonacci price points
Since you’re looking at long term stock market cycles, I’d suggest using a weekly chart for this.
Using Options Data to Predict Stock Prices
Another highly valuable tool for picking the duration of the right options using is free options data to forecast price movement over a given time frame. This data is right on your brokerage platform.
Click here to read my post Using Options Data to Predict Stock Prices.
And click the image below to watch my video on using options data to predict stock prices.
6. Choose the Right Futures Duration
Futures contracts have a certain duration. Choose a duration based on the period of time you expect a market downturn.
For example, if you are concerned that the market may fall within the next three months, choose a contract that expires three months from now.
You’ll use the technical analysis and options data explained in step 5 to choose the duration of the right futures.
For example, let’s say you are concerned that the market may go down in the next three months. You’ll sell a contract that expires in three months.
Perfect timing is impossible to predict. If your timing is off, you can roll the futures contract as explained more in Step 7.
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7. Decide If You Should Roll the Futures Contract
When a futures contract is close to expiration, you can buy it back and sell a new one that doesn’t expire until much later. This is called “rolling” a contract.
In the above example, you picked a futures contract with a three-month duration. Two and a half months later, the market hasn’t gone down.
But you are still concerned that the market may go down in the next three months. You can roll the contract into a new one, giving you an extra three months of protection.
Rolling a three-month futures contract into a six-month one is a little more expensive than simply buying a six-month contract in the first place. But in many cases, it may be the best option.
That’s all there is to hedge a stock portfolio with futures.
Hedging Stocks With Futures Vs Options
You’ve seen how to exactly hedge stocks with futures. You may be wondering about hedging with options instead of futures.
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Options or futures can certainly be used for hedging stocks but there are a couple of big benefits of using futures to hedge stock portfolios.
- First, it can be more expensive to buy put options than it is to sell futures.
- Options depreciate in value due to time decay, but futures don’t have time decay.
- Both options and futures contracts can be rolled. But since options experience time decay, as mentioned above, it’s more price efficient to roll futures should you need to extend downside stock protection.
As you can see, the benefits of hedging with futures are significant.
There is one big disadvantage to hedging stocks with futures instead of options. If the stock market does go up, the value of the futures that you’re short will go in the opposite direction, or down.
This happens less with options because all you can lose is the amount you paid for the put option when you bought it.
Hedging Stocks with Futures Conclusion
Hedging a stock portfolio with futures can be a great way to protect yourself against downturns in the market. Bear markets are, unfortunately, a reality for all stock investors.
Hedging with futures can be a sensible way to lower your investment risk.
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Images:
“Img02,” by Tokyo Financial Exchange: https://www.tfx.co.jp/en/retail/cfd.html accessed 5-9-2019
