Many traders are having a hard time coping with market volatility, and the markets have certainly been volatile recently. We have to remember markets can move against us quickly, and it’s important to have appropriate risk-control measures in place, particularly when trading in a leveraged market such as futures. If you are worried that market volatility will negatively impact your stock market portfolio, stock index futures can be a valuable hedging tool.
The markets are very confusing and choppy right now, and low volume has exacerbated these moves. We’ve seen large intraday swings with the market reversing course dramatically by day’s end. We are getting mixed economic numbers and it’s difficult for investors and traders to decipher which are important. However, volatility also creates trading opportunities for bulls and bears alike. Let’s outline the case for both the bulls, and the bears in the stock market.
Case for the Bulls
While Europe struggles, emerging countries are picking up the slack. The “BRIC” countries (Brazil, Russia, India and China) are still growing. The long-term fundamental story is strong for these countries—I don’t believe they are creating bubbles.
China recently announced it would relax its currency peg to the U.S dollar, which is positive overall for the markets. It makes commodities more attractive and exporting multinational companies should benefit from the increased purchasing powr of the Chinese consumer.
In addition, fears of a double-dip global recession seem to be fading. On June 7, U.S. Federal Reserve Chairman Ben Bernanke said the U.S. recovery remains on track and that the country should avoid falling back into recession. “So far, it is pretty good…we will have a continued recovery,” he said.
We’ll have to see what sort of statements the Fed will make after the conclusion of its two-day monetary policy meeting on June 23, but no increases in interest rates are expected until the beginning of 2011, at the earliest.
Right now, companies are lean, with great operating leverage. They should be able to generate good profits. The markets seem to calming from the sovereign debt panic we saw in May, and investors are starting to see a longer-term valuation play. By historical standards, stocks are looking pretty cheap. The median PE ratio for S&P 500 stocks from 1920 to today is about 15, and we have some Dow stocks trading at less than eight right now.
Case for the Bears
There is a lot of bearish sentiment in the market. The stock indexes have been sea-sawing around, and it’s been hard to get a sustained rally going as investors have had a mentality of selling into strength.
The S&P 500 futures closed below their 200-day moving average on Tuesday, June 22, which is technically bearish. I don’t know if the S&P will fall as low as 1,050, but a break there could lead to a very significant fall. It’s a good technical point to watch. I think we need a positive catalyst to boost the market further.
Market bears are predicting a rough third quarter. Unemployment is still persistently high in the U.S., as reflected in weekly jobless claims figures. The last U.S. monthly employment report was disappointing, with gains coming primarily from temporary government Census workers. The economy needs to shift to get these workers back into new areas of employment. Taxes will likely go up at some point next year in the U.S., and interest rates are going to eventually go up too—both potentially negative factors for the market.
The uncertainty in Europe isn’t likely to subside anytime soon either, and investors remain nervous about a sovereign debt default. What started as a consumer debt issue in the mid 2000s moved to financial institution balance sheets during the financial crisis of 2008 – 2009, and now we’ve seen a shift of these liabilities to government books.
In addition, Congress in the U.S. is trying to quickly push through a financial reform bill, which could have negative implications for the markets. The bill raises capital standards for bank holding companies and bars certain preferred securities from being used in measuring bank’s capital strength. It also bans risky trading by banks and requires banks to spin-off their swaps units, capping future profits.
The cost of banking will likely go up as a result of this bill if is passes as it stands, and it could decrease the competitiveness of the U.S. banking system. Fees will be passed to customers, and it could exacerbate unemployment trends.
From a technical perspective, the daily chart of the Dow Jones Industrial Average shows a possible bearish head-and-shoulders pattern. If the market breaks the neckline and completes the pattern, we can take a measurement of the head to calculate how far down the market may move further.
Trading Opportunities
If you are a market bull, you can buy stock index futures contracts or calls on S&P 500 futures to speculate on potential gains in the market. If you are a bear, you can also use stock index futures to hedge a current equity-based portfolio quickly and in a cost-effective manner. The CME Group E-Mini S&P futures offer exceptional liquidity, and the leverage provided by futures allows you to use less capital. You don’t need to be a stock picker—you just need an opinion about overall market direction.
If you anticipate the stock market will decline 10 percent during a given timeframe and you want to protect your current equity holdings, you would need to determine the appropriate futures contracts to hedge, in the right amount to offset your stock losses. In this example, I will assume a hypothetical $1,000,000 portfolio, expected to lose $100,000 in value. I will also assume the S&P 500 is trading at 1,115.
Example: Hedge against a 10% market decline by selling S&P E-mini futures
Equity portfolio value = $1,000,000
Expected loss in value = $100,000
E-mini S&P contract = $50 per each point move
E-mini notional value = $50 x 1,115 = $55,750
Portfolio value = $1,000,000/$55,750 = 18 futures contracts needed to hedge
Change in value of the index = 1,115 x 0.1 (10 percent loss) = 111.5 pts x $50 – $5,575 potential profit or loss
$5575 profit/loss x 18 contracts = $100,350
So the profit on your 18 short futures contracts will be $100,350 if the market falls 10 percent, offsetting the losses in your equity portfolio. If the market rallies 10 percent, that would be your loss on the futures position. Of course, this is just one example. You can also use puts on the S&P 500 as a hedge, and there are many other types of hedging strategies you can pursue in other markets as well.
Kyle McEwan is a Market Strategist based in Lind-Waldock’s Toronto office, and is serving clients in Canada. If you would like to learn more about futures trading, you can contact him at 877-840-5333 or via email at kmcewan@lind-waldock.com.
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