Hedging Using Futures and Options on Futures

Everyone knows that these are very difficult times for investors, across a variety of asset classes. Futures and Options on Futures can be an extremely effective way to hedge against a declining stock portfolio.

Futures and Options inherently carry more leveraged risk than do other investment vehicles, however there are many strategies that have limited risk and virtually unlimited reward potential. One such example would be the purchase of a put or a call option.

The risk is limited to that of the cost of the option. The profit potential is the strike price of the option, plus or minus the current market price.

For example, an E-Mini S&P 500 Put with a strike price of 900, with the underlying futures market trading at 850, will have an intrinsic value of 50 points (which equals $2500) plus time value and any additional value associated with increased volatility.

Hedging with Futures against a physical portfolio of stock is also possible. For example, consider the contract specification for the S&P 500 Futures product. It is valued at $250 times the Standard & Poor’s 500 Stock Price Index, where 1 point = .01 index points = $2.50. The minimum fluctuation is 0.10=$25.00.

If the S&P index is trading at 900, this means that one futures contract will hedge $225,000 worth of stock in the S&P 500 Index (900 * 250) = $225,000.

Note that many of the larger indices offer “mini” contracts, such as the E-Mini S&P Futures contract. This contract is only 1/5 the size of the Big S&P contract. One E-Mini S&P contract will hedge $50 * Index value (i.e. 50 * 900 = $45,000). This helps individuals with smaller equity portfolios to hedge, as the contract size is smaller.

The Dow Jones Futures and Russell Futures contracts also offer both E-Mini Russell and Mini Dow contract sizes. If you are interested in viewing the way a contract specification is presented, I recommend you visit the exchanges’ website for the products in which you are interested. The link to the Chicago Mercantile Exchange’s (CME) contract specification page for equity products is located here.

The same principle can be applied to any market, whether it’s foreign currencies, energy products, metals or grains.

Important note: this article focuses on futures and options on futures as they can be used for hedging purposes. It is not intended to encourage speculation. To the hedger, if properly hedged, declines in a physical asset are offset by gains in the hedge instrument.