How to Hedge With Stock Index Futures

Use futures to protect a portfolio.

An investor with a large portfolio of stocks may want to hedge against a stock market decline by using futures contracts. A hedge is purchasing a derivative security that will generate profits to offset any losses in the portfolio and still allow the portfolio to accumulate gains if the market goes up in value. Futures are popular for hedging because of the liquidity of futures contracts and the different stock market indexes that are represented by futures contracts.

Instructions

1. Determine which stock market index best reflects the composition of your stock portfolio. The Dow Jones Industrial Average is an index of large, blue chip stocks. The S&P 500 is a broad market index. The NASDAQ 100 index is primarily large tech stocks. Pick the index that is the closest match to your portfolio.

2. Determine whether you will hedge with the standard or"e-mini" futures contracts. The standard contracts will hedge a larger amount of stock with a single contract. The standard contracts will provide hedging for $250,000 to $300,000 per contract. E-mini contracts have a stock value of $40,000 to $60,000.

3. Calculate how many futures contracts you will need to hedge your stock portfolio. The value of a futures contract is the futures price times a multiplier. The futures price will be very close to the stock index of the specific futures contract. Multipliers for the futures listed above are for the DJIA: 5, 10 or 25. For the standard S&P500 and NASDAQ 100: 250 and 100, respectively. E-mini S&P and NASDAQ 100 multipliers are 40 and 20. For example, the NASDAQ 100 has a value of 1,980, so the e-mini contract covers $39,600 worth of stock. You have a $200,000 tech stock portfolio, so you would need five e-mini NASDAQ 100 futures contracts to hedge your portfolio.

4. Sell the futures contracts short. Futures sold short will increase in value as the stock index declines. Futures contracts require a margin deposit for the contracts traded. The deposit requirement is set by the futures exchange and is 7 to 10 percent of the contract value for stock index futures. The e-mini NASDAQ 100 futures have a margin requirement of $3,500 per contract.

5. Monitor the price of the futures contracts and the tracked stock index. As the index declines, the value of the futures position will increase to offset the losses in your stock portfolio. If the stock index goes up in value, be ready to close out the futures positions to avoid a large loss on the hedging contracts.

Tips & Warnings

• Futures contracts must be traded through a broker registered with the U.S. Commodity Futures Trading Commission.

• Futures have a wide range of expiration dates out to two years. Hedging is usually a short-term tactic using one- to two-month futures contracts.

• Index futures settle for cash. If you have a profitable hedge, the hedge profits will be deposited in your account when the contract expires.

• Futures contracts can be purchased long or sold short without restriction. Selling short creates profit in a declining market. Placing a long order will offset the short position and close it out.

• Hedging with futures will cost the individual investor 7 to 10 percent of the portfolio value. If the market does actually decline, this cost will be recovered. The hedging costs will be a total loss if the market moves in the other direction.

• Trading of futures can result in losses greater than the initial margin deposit. Using future to hedge should only be done by investors who can constantly monitor their portfolio and the market.

References

• CME Group: Equity Index Futures