Stock Index Futures

With so much volatility in the markets these days, many of you may be wondering: how can I reduce the risk of my portfolio without selling out of my long (or short) equity positions? The answer: stock index futures.

A stock index tracks changes in the value of a hypothetical portfolio of stocks. We all can name the major broad-based indices across the globe: the DJIA, S&P 500, FTSE 100, and many others. These benchmark portfolios can be used to hedge (reduce) the risk in well-diversified equity portfolios by using futures contracts.

Futures are exchange traded derivatives; which is to say, they are standardized contracts traded on regulated exchanges. In Canada, all futures trade on the Bourse de Montreal; the largest futures exchange in the world is the Chicago Mercantile Exchange (CME). By combining the cost-efficiency of futures and the breadth of stock indexes, investors have a power tool to significantly diminish their exposure to risk without drastically altering their portfolios.

For example, let’s say you are a long-term investor. You may feel that you have “picked” some winning stocks in your portfolio, and you expect they will outperform the market. However, due to recent market events and economic data, you are concerned about possible short-term downturns in the market. In this scenario (a likely one for many investors closer to our parents’ age) it may well make sense to utilize stock index futures.

Let’s assume an investor has a portfolio of $1 million and has bought many large companies traded on the S&P 500. On February 4th, the S&P 500 closed at 1,381; we also know that each futures contract for the S&P 500 trades for $250. Thus, the current value of the stocks underlying one futures contract is 1,381 x $250 – let’s call that $350,000 to keep it simple. To calculate the number of futures contracts to buy or sell, divide the total value of your portfolio ($1 million) by the value of the underlying stocks ($350,000). In our hypothetical scenario, our investor needs to (in this case) short about 3 futures contracts of the S&P 500. Since we have assumed that the investor is “well-diversified,” this example implies a beta of 1.0 for the portfolio. If you have a particularly risky portfolio compared to the market (a beta of 2.0, for example), you use twice as many futures contracts. This technique could also be used in reverse if you hold short equity positions, and you expect the stock prices to rally in the near future (in that case, you would buy stock index futures that mirror your portfolio).

Why would an investor do this? Again, if the person hedging the portfolio feels that the stocks in the portfolio have been chosen well, this strategy makes sense since it eliminates the risk of the market. Another reason to do this would be if the hedger is planning to hold the portfolio for a long period of time and requires short-term protection in an uncertain market situation. Indeed, many people with a clever investment advisor may have received this advice once the subprime fiasco grabbed hold of the market late last summer. Remember, while an investor still holding long equities may have their gains wiped out, their portfolio value would be safe because they bet against the market. Finally, the alternative strategy of selling the portfolio and buying it back later would likely involve unacceptably high transaction costs.

In summary, hedging is a way to reduce risk. Stock index futures – such as the S&P 500 traded on the CME, can be used to hedge the systematic risk in an equity portfolio. In simpler terms, instead of selling all the stocks in your portfolio, you can short the market (using futures contracts on stock indices). Now, your portfolio is exposed only to the risk associated with each stock, and not to market fluctuations. This is a valuable tool that has very real-world applicability to investors like you and I. Of course, you can’t do this on investopedia, but hopefully next year this could come in handy!