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Teaching Goblins to Trade: Using Futures to Hedge Stocks

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April 28, 2015

The idea of hedging a stock portfolio with low-cost index futures can make you feel like that anxious kid again. Something spooky and unpredictable with every trading day, right? Maybe not. Bear in mind, hedges can be expensive. Before implementing a hedge, consider booking some of your gains, and rebalance your portfolio to the right risk level. Doing so can help reduce your exposure and how much you need to hedge. With more cash in your portfolio, you can buy at lower prices when the correction actually occurs.

Greek Never Scary  

If you’re holding a book of large-cap stocks, the E-Mini S&P 500 index future is a common hedge and can have very cool potential tax, settlement, and liquidity benefits. The question is, how much is enough? Trader, meet beta.

Beta is a ratio that compares a stock’s volatility to a benchmark, usually the S&P 500. If a stock has a beta of 1.50, it’s approximately 50% more volatile than the S&P 500 with a beta of 1.00. In other words, for every 1% price move in the S&P 500, the stock is expected to move 1.50%. “Beta-weighting” your portfolio helps you understand each component in like terms. It’s like turning both apples and oranges into bananas. Measuring bananas for everything makes the process easier.

Delta describes the value magnitude an asset is likely to gain or lose, given a one-dollar move in the benchmark. For example, 100 stock shares with a beta-weighted delta of 70 would change $70 in value for every dollar change in the S&P 500. Add up the beta-weighted deltas of your positions and you have your delta. Consider the portfolio in Figure 1, beta-weighted to the E-Mini S&P 500 Futures continuous contract (/ES). 

beta-weighting futures options in thinkorswim

FIGURE 1: MEASURING BETA

In thinkorswim® click the “Activity and Positions” subtab under the Monitor tab. Check the “Beta Weighting” box in the upper right corner and type in “/ES” to compare your portfolio to the S&P 500 E-Mini index future. #1 above shows the beta-weighed Portfolio Delta, while #2 shows we're beta weighting with /ES. For illustrative purposes only.

Each position’s delta is expressed in beta-weighted terms of /ES, with the delta displayed as approximately 200. In other words, this portfolio of bananas will gain or lose approximately $200 for every one-dollar move in /ES.

Pick Your Demons Wisely

Now that you’ve wrangled your portfolio into measurable terms, the last step is choosing how much delta you want to offset. It’s common to shoot for a 30–50% range, while keeping the capital requirement to no more than 3% of the portfolio value. (A 100% hedge is often impractical and expensive, in which case it’s best to evaluate your book’s basis instead.)

To target a nearly 50% hedge above, we’d need to sell enough /ES contracts to produce -100 deltas. The following table shows how selling two /ES contracts would offset the target deltas at a cost lower than 3% of the portfolio. 

For illustrative purposes only. 

Not for nothing, deltas change over time as the market moves. Depending on how long you keep the hedge, you may need to adjust several times to keep it aligned with target percentages.

Remember, hedges are often temporary by nature. If your temporary hedge becomes permanent, it may be time to rethink objectives, and just how much Fright Juice you want stashed in the fridge.

Open a Futures Account

For qualified accounts, you’ll need Level 3 options approval to trade futures. Log in to your account at tdameritrade.com. Under the Trade tab, go to Futures & Forex for more information.

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