If you manage a portfolio or trading account. one skill set that is very helpful to develop is hedging with futures. Portfolio risk can be defined. We can use tools. like the beta weighting tool in Thinkorswim. to define our overall portfolio risk. Many brokers have similar tools. The basic idea goes something like this: tabulate all of the positions you hold in your portfolio and use software & tools to help you understand your total risk.
If you own 30 different stocks, each of them will have its own individual risk. You can manage them individually, and you need to. You can hedge them individually, and you should know how to. But what if you could use 1 product and 1 position to hedge off the risk of all 30 stocks at the same time? You can. You can calculate the total risk of the 30 positions and then use products like options or futures to hedge the risk.
Using options brings in the option Greeks. Which for some traders is an advantage because they know how to read and use the Greeks in their favor. For others who can’t read them, though, it can lead to complications. Futures contracts only bring in 1 basic Greek, which is Delta. Since futures operate on leverage, you can use a small amount of money to hedge off the total risk of a large Delta.
Hedging with futures isn’t limited to stock or equity portfolios, either. You can use futures to hedge off account risk even if the portfolio is mixed with options and stock or options alone. The more stuff you have, and the more instruments you use, the more knowledge you’ll need to be able to accurately hedge.
Let’s consider an example. If you have a portfolio with 10 stocks and 10 options trades, you use the tools, you get the math, and it tells you that you have 500 positive delta points beta weighted to the SPY. This means that if the SPY goes up 1 point, your portfolio should go up 500 dollars. If SPY goes down 1 point, your portfolio would drop 500 dollars. How can you hedge?
If you wanted to be ‘delta neutral’ because something is happening in the market you’re nervous about, a technical signal pops up on the chart that screams that the SPY is going bearish, or you just aren’t comfortable holding that much delta, then you can hedge with stock, options, or futures. If you hedge with stock, you’ll need -500 shares of SPY. This is expensive to hold. If you hedge with options, you need -500 delta points. This is less expensive to build, but brings in the Greeks. If you hedge with futures, you need roughly -1 S&P E-Mini contract.
Are any of the tools above perfect? No. They all have advantages and disadvantages. Is hedging mandatory? No, it’s a choice some traders and investors make. Do you need to hedge your entire delta? No, you can hedge the amount you wish to control, or ‘over-hedge’ to turn your portfolio in the opposite direction. Can you hedge bullish or bearish portfolios? Yes. You simply need to build the appropriate hedge. What if the hedge loses money? Then it lost money. The point of the hedge isn’t to make or lose money independently, it’s to control the risk of the overall portfolio.
If you’re going to hedge with futures, consider that you’ll need approval to trade futures, understand the risks and costs associated, and practice using these techniques in a practice environment before you do it in a live environment.
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