by Chris James

Many investors make a long-term commitment to invest for their retirement, yet find the short-term gyrations of the stock market test their patience.  We are rightly told to “hold and not to over-trade” since in the “long term,” missing a few really good days can devastate overall returns. If you are 100 percent in cash, you also miss any potential dividends stocks can provide. Must you give up sleep when you take on risk in the hopes of achieving decent returns?  What actions can you as an individual investor take to reduce portfolio volatility? How much will it cost?

Commodity futures contracts on the major North American stock indicies provide a liquid and low-cost vehicle to hedge against stock portfolio volatility. The popular E-mini futures contracts on the S&P 500 stock index, the NASDAQ 100 and the Dow Jones Industrial Average are sized for the small investor and trader and are traded at CME Group.

The E-mini S&P 500 is priced at $50 (USD) per index point. This means the contract’s full value is $50 times the index level; so if the index is at 1,300, full value would $65,000 (USD).  If you have a portfolio of large-cap and mid-cap stocks in the U.S. market with a current market value of around $65,000, there is a good chance your portfolio’s value will fluctuate in line with the changing value of one E-mini S&P futures contract.

Determine Your Hedge
The percentage change of your portfolio should match the percentage change in the futures contract chosen for hedging the risk. The variance from the change in a stock index value as compared to your portfolio’s percentage value change is termed the portfolio’s beta. Simply, if the index moves up 10 percent and your portfolio has a beta measure of 1, then your portfolio will tend to move up likewise; that is by 10 percent.

If your portfolio has a beta of 1.5, then the value change of the portfolio will be 1.5 times the percentage change of the stock index. That is, instead of 10 percent it would be 1.5 x 10 percent = 15 percent.  By combining the beta with the multiple of E-mini contracts required to match the returns of the stock market in general to the returns of your portfolio is quite simple: ( Portfolio size in $ ) divided by (E-mini S&P futures current value) times (portfolio beta) = number of E-mini S&P contracts required to replicate the value change of your portfolio.

A higher beta portfolio of banking stocks and consumer discretionary stocks with some high-tech stocks (or ETFs for that matter) would require more E-mini S&P contracts to hedge the risk than lower-beta dividend stalwarts like utilities and consumer staples. Here is an example of a high beta portfolio hedge calculation:

$150,000 portfolio of IYG (Dow Jones Financials Services ETF) / $65,400 (E-mini S&P futures current value) x IYG beta of 1.4 = 3.21 contracts of the E-mini S&P futures that are required to be sold to hedge downside value erosion in the investor’s IYG holdings. Of course we cannot trade 1/5 (0.21) of an S&P 500 E-mini contract. One solution is to use an options spread in such a way to as to replicate the percentage price change of the S&P 500 futures with the equivalent actual dollar gains in a bearish synthetic of short call options and long put options on the S&P 500 E-mini futures with a delta of 3.21.

The problem here will be obvious: it is getting complicated! And option hedges have to be reset day-to-day, adding to the transaction cost of this hedge. An alternative is to seek futures contracts that correlate to the stock index but are a different and more convenient size.

The Canadian dollar futures contract has had roughly a 90 percent correlation to North American large caps. It is also a $100,000 Canadian currency size with a value currently of $101,000. Correlation is a less exact way to select a hedge but we need not have a perfect hedge. Rarely does a perfect hedge exist, but it can provide very good diversification. Following the same formula I used in the IYG example, I will now substitute a Canadian dollar futures contract.

Example: $150,000 IYG portfolio holding value / $101,000 value of C$ futures contract in USD x IYG beta of 1.4 = 2.08 C$ futures contracts that are required to be sold short in order to hedge downside risk in the IYG portfolio holding.

Other futures contracts can also from time have similar correlations, and it is up to the individual investor to select the contract which best fits the hedge equation and gives a whole (or almost whole number) number answer. Of course, if you aren’t experienced with futures, it is recommended you seek the help of a professional to assist you. Here at Lind-Waldock, we can help you determine an appropriate strategy. Also, margin deposits for futures vary from contract to contract and that is something you need to be aware of, and account for. Trading and hedging is an art–not a science! Market conditions and correlations are not set in stone so active trading in futures for hedging portfolio risk must be reviewed regularly.

Costs
The monetary outlay to trade futures (margin) is generally much lower than the required monetary outlay for shorting equities in a classic long/short market neutral strategy. Please keep in mind that while the use of leverage is one of the features many investors find attractive about futures, it also carries added risks. If you don’t understand how leverage works, please speak with a Lind-Waldock professional to help you understand the concepts.

Online trading commissions for futures trading varies and may at first seem higher than equity trading, but when you do the math, trading futures can be quite cost-effective. Let’s look at an example of the “cost math” using the C$ futures example. We will assume commissions are $75 per round turn for two contracts, but might be more or less in a real trading account.

Margin for two C$ futures is $4,860 (subject to change). According to my calculations, active trading in futures to hedge the IYG portfolio risk would cost ($4,860 + $75) / $150,000 = 3.29 percent. Of course with futures when you no longer need the ‘insurance,’ you get the margin deposit back. That makes the true cost closer to 0.05 percent. In other words, you can wind up just paying the commission.

This article just scratches the surface in terms of how you can use futures to hedge your portfolio. I encourage you to contact me to learn more. I’d be happy to answer any questions that you have about futures trading.

Chris James is in Business Development in Lind-Waldock’s Toronto office. He can be reached at 1-800-268-9294 or via email at cjames@lind-waldock.com.

Futures and Forex trading involves a substantial risk of loss and is not suitable for all investors. Past performance is not indicative of future results. Please carefully consider your financial condition prior to making any investments. Not to be construed as solicitation.

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