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Futures Trading as a Hedge: Not Just for Farmers Anymore

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July 1, 2012
Futures Trading 101 hedging
Fredrik Broden

Mention futures trading at a party and your friends will likely think of farmers and pork bellies. Then there's Hollywood, which often tells the story of the little guy making fortunes while the bad guys go broke. That's what trading futures is all about, right? Well, not exactly. At least not if you ask smart investors and traders.

Futures trading is certainly not appropriate for everyone. Trading futures does involve speculation and the risk of loss can be substantial. But, the idea that futures are for professionals only—industrial-sized users, or farmers of some commodity, or some big financial institution, or central bank looking to hedge, ganged with fire-breathing speculators taking the other side of the risk—is Hollywood. It's a fun story, but not practical.

In fact, futures trading can be boringly practical. The concepts of hedging and speculation are still true, but it's how you hedge or speculate with futures that can make all the difference. You can use the same strategies as the pros, but on a much smaller, and less leveraged scale. Here's how.

Putting the Drink Down

Let's start with a sober discussion of what a future is by talking about the E-mini S&P 500 future, the electronically traded little brother, of the S&P 500 future (SPU). You're probably familiar with the S&P 500 index, calculated off the prices of 500 large-cap U.S. stocks, and which has a price. The E-mini S&P 500 future is a contract that that would deliver the cash equivalent of $50 times the price of the S&P 500 index, at the expiration of the future.

So, if you thought the S&P 500 might go higher, you could go to the trouble of buying all the 500 component stocks in the same weighting method that the index uses. Or, you could just buy an E-mini future. You would put up some cash to cover the initial requirement for the futures contract. You'd profit if the E-mini future went higher, and lose if it went lower. Now, you may have mutual funds that track the S&P 500, so you may be asking, why all the fuss about futures?

When you multiply the price of the S&P 500 future by $50, you get the value of that future. With the S&P 500 future at 1,300, it has a value of $65,000. The initial margin requirement, or the amount of cash you need in your account to buy that future, is about $4,400. Using only $4,400 to establish a position worth $65,000 is known as leverage. And some say it's both a good and bad thing about futures. Good in the sense you don't need the full value of the contract to buy it. Bad in the sense you don't need the full value of the contract to buy it.

If the SPU moves up 50.00 points in a week—not a huge move for the S&P 500 future—you'd make $2,500. But if it drops 50.00 points, the loss would be $2,500, and you'd have lost over 50% of your initial investment. You may also have to put up more cash to maintain the position. That's called a margin call, which must be satisfied immediately. In that sense, leverage is kind of scary. But what if you actually had a portfolio of S&P 500 stocks worth $65,000? That doesn't have any more risk than the S&P future. Finally, what if your stock portfolio is smaller? Are there any advantages to buying an E-mini future than a basket of the S&P 500 stocks?

Small Shots Can Work, Too

Let's say you'd like to invest in an S&P 500 portfolio with a value of $65,000. What are your choices?

1/ You could buy $65,000 worth of an S&P 500-tracking mutual fund.

2/ Alternatively, you could buy $65,000 worth of an exchange-traded fund that tracks the S&P 500, and if you chose to use margin, you'd only need to put up $32,500 to do that (remembering the cost of margin interest also, when borrowing from your broker).

3/ Or you could buy 1 E-mini S&P future, and put up about $4,400 in margin.

Note that in scenario 3 you have not bought any actual securities like you did in the first two scenarios, but you've bought a product where the risk/reward profile is similar. And if you had remaining capital (since you did not have to spend $32,500 or $65,000), you could conceivably invest that in an interest earning product. That could help diversify your overall portfolio, or even enhance your potential return.

Rather than leveraging up to take more risk, you'd be using leverage in an attempt to enhance returns. Fire breathing? Not so much. Unlocking some capital? Yes. Time for that martini.

Many futures—like the E-mini S&P 500—are traded nearly twenty-four hours a day, making real-time information available in the middle of the night. You can even trade futures on a mobile platform, such as TD Ameritrade Mobile Trader. (See “Go Outside and Trade!” page 26 of this issue for more.) And you can trade a wide variety of markets with futures— from commodities like corn, soybeans, and crude oil, to financial instruments like Treasury bonds and currencies. Futures can be a way of speculating or hedging these products because of several things—liquidity, electronic quoting and order routing, and availability of futures accounts (have you ever tried to buy 1,000 barrels of crude oil?).

Those S&P 500 futures are also frequently viewed as a heads up on what might be happening in the market. Ask any active trader what things she checks daily, and you're likely to hear “the SPUs.” That's because the speed and efficiency of the futures markets help professional traders make either bullish or bearish speculative trades on futures faster than buying or selling entire portfolios of stock. When some news or event hits the wires, generally the product that reacts first is the S&P 500 future. Often, you might see the S&P 500 futures rally before you see the component stocks of the index rally. There's no guarantee that individual stocks will follow the futures, but the futures can give you an indication of how market participants might be interpreting a news event as either bullish or bearish on the overall market. To check it out yourself, put the symbol /ES in a watch list.

Backyard Hedges

Speculating with futures is one way to use them. But, what if you want to reduce the risk of adverse price movements on everyday things like gas prices at the pump, heating oil, your stocks, or even your adjustable mortgage against rising interest rates? Now, this isn't the traditional hedging strategy of the futures market, and the same pros and cons of leverage apply. But the tricky part is contract size. Remember the part about the price of the S&P 500 times $250 for the “big” SPU contract, and times $50 for the E-mini? Those are contract sizes. And they affect how much of an underlying position a future can hedge.

Using even an E-mini S&P future to hedge a $10,000 stock portfolio would be overkill. You need to be familiar with the mechanics of futures contracts in order to use them as a hedge. Let's look at a few examples.

Portfolio protection. It doesn't take a rocket scientist to understand that oil stocks are affected by rising oil prices. Or that metal miners might be affected by the rising price of gold. If you had a portfolio of stocks or funds as a long-term investment that broadly tracks the S&P 500, and that you don't want to liquidate, the E-mini S&P future could be used as a “hedge.”

Let's say the value of your portfolio is $100,000 and you’re concerned that the market might drop 10%. You could consider shorting E-Mini S&P 500 futures as a hedge. But how many? If the market drops 10%, your portfolio would theoretically lose $10,000 in value. If the E-mini is at 1,300.00, a 10% drop would mean 130 points. Each point in the E-mini is worth $50. So 130 points times $50 equals $6,500. So, if you shorted an E-mini future, and the market dropped 10%, theoretically your portfolio, in conjunction with the short future, would lose about $3,500 of value. The strategy isn't perfect— your portfolio still loses money if the market drops—but the intention would be to lose less than if it were unhedged. And remember, the risk associated with the futures position doesn't change. If the market rises suddenly instead of dropping you need to be aware of your exposure.

Lock in on your adjustable home loan. Let's consider a scenario where you're borrowing $500,000, with an adjustable rate tied to 10-year bonds. (Or if you don't have a home loan, think high-balance, floating-rate credit card here.) If you believe interest rates might rise by 1.00 (100 basis points), you'd have to pay an extra $5,000 in interest per year if that happens. A possible strategy to reduce the risk of adverse price movements would be a short 10-year Treasury bond future (symbol: /ZN). If interest rates rise, bond prices drop. But how much does a 10-year bond future change when interest rates change 1 % ? According to the Chicago Mercantile Exchange, nearly 8 points. Each point in a bond future is worth $1,000, and 8 points would be worth $8,000. If rates do rise by 1 %, you'd have to pay $5,000 more on your loan. But, theoretically you'd earn $8,000 on your 10-year bond future hedge. Again, this is a case where the hedge isn't perfect, but the point is to understand how to apply futures point values as a strategy to offset risk.

Home economics and the heating bill. Using the same principles as interest rates, how about offsetting your heating bill against rising energy costs? Only this time, you might use natural gas futures (symbol: /NG), the primary source of residential heat. Want to hedge against a rise in prices at the pump? Consider futures on crude oil (symbol: /CL). Just remember the risks involved in futures trading, and the ever present effect of leverage. These days, there's likely a future that you have access to for just about any bill or expense that's tied to a commodity of some sort.

To trade futures either for pure speculation or in an attempt to reduce the risk of adverse price movements, you need to do that in a futures account. You can't trade futures in an equities account. But you don't need a futures account to see futures quotes on the TD Ameritrade platforms, and opening a futures account with TD Ameritrade is very straightforward. 

Don't Have a Futures Account?

To trade futures at TD Ameritrade, you need to have Level 2 options approval prior to fill out the futures application. To apply, contact us at support@thinkorswim.com or call 866-839-1100. 


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