Futures are a powerful tool for risk management. A futures contract is an agreement to buy or sell a certain amount of a commodity or financial product at a future date. They’re traded on exchanges and cover all sorts of asset classes; stock indexes, interest rates, currencies, commodities.
You can use futures to protect your portfolio from unexpected events like financial crises or unpredictable election outcomes.
Hedging with Futures
Hedging against global event risks with futures can reduce potential losses. Futures are agreements to buy or sell an asset at a future date for a fixed price. They allow you to lock in prices and make decisions based on market moves.
Futures are highly leveraged, so you can control a big notional with a small amount of capital. You can hedge a large part of your portfolio with a smaller initial outlay.
Pros
- Hedge large portfolios with smaller capital.
- Trade almost 24/7, 6 days a week.
- Respond to events outside U.S. market hours.
Cons
- Leverage can amplify losses.
- Small price movements can have big impact on gains and losses.
- Trading Hours for Flexibility
Futures’ near 24/7 trading hours give you more flexibility. You can hedge your portfolio against global events even when the U.S. markets are closed. That’s especially useful for reacting to international news or events that affect your investments.
Futures hedge example
Let’s say you have a stock portfolio that’s mostly SPX (S&P 500) and you’re worried about an upcoming economic report that will cause your portfolio to decline. You want to hedge part or all of your portfolio by selling the E-mini S&P 500 (ES) futures.
To determine how many contracts to short, compare the percentage of your portfolio to be hedged to the notional value of one contract. To find the notional value of the ES, multiply the price of the contract by $50.
Here’s how it works: If the SPX falls and the ES contract drops 50 points (about 1%), you might close out that futures position to lock in a gain. That gain can help offset unrealized losses in your stock portfolio. By trading in the futures market you get similar notional exposure with less capital tied up.
Long or short, futures can be a good hedge. But short positions have unlimited risk if the price of the shorted position goes up. If properly hedged, the risks of short positions can be offset by gains in your long positions.
