Perhaps you made a bold investment decision to buy some stock that paid off with a handsome price rise and now you are a little nervous. You don’t want to sell the stock, because you feel it might go a little higher or because you don’t want to pay taxes on the capital gains just yet. The solution is to hedge your stock position with a futures or option contract. Options work well to hedge individual stocks, but futures contracts are very efficient hedges for stock funds. Futures are equally useful for hedging bonds and commodities.
You can protect your unrealized profits with a put option. You would buy a put for each 100 shares of stock you want to hedge. A put contract allows the option buyer to sell 100 shares of the underlying stock at a specified price, the strike price, until the option expiration date. If you own 200 shares of XYZ Corp. stock that rises in price from $25 to $45 a share, you have a $4,000 profit to protect. To do so, buy two put options with a three-month expiration and a $45 strike price. Expect to pay a few hundred dollars for each put. No matter how low the price of XYZ stock falls during the lifetime of the put, you can sell your shares for $45 each. If the stock rises, the puts will expire as worthless.
It’s possible that you wouldn’t mind selling your XYZ stock, but not for less than $47.50 a share. You can sell two call options with a $47.50 strike price. You will receive an immediate premium payment of a few hundred dollars per option, which is yours to keep. If the stock remains below the strike price until the call expires, you keep your stock and can repeat the process to collect another premium. Eventually, the stock may rise above the strike price, at which point your shares may be called away from you. If this happens, you will receive $47.50 per share on top of all those premiums you collected. This strategy will not protect you from a downswing in the price of XYZ, but the premiums will cushion the loss.
You can use futures to efficiently hedge a position in a stock index fund. For example, suppose you have purchased 500 shares of an exchange-traded fund tied to the S&P 500 stock index. Assume also that the ETF is now worth $150 per share, giving your position a value $75,000, and that the index stands at 1,500. The Chicago Mercantile Exchange offers an E-mini S&P Futures contract valued at $50 times the S&P 500 index. You can sell one $75,000 contract that will change in value by $50 for each one point change in the index, which corresponds to a 10-cent change in the ETF. You are now fully hedged against loss for the life of the contract.
Margin and Daily Settlement
You don’t have to put up $75,000 to sell the S&P 500 futures contract. Rather, you need to deposit $3,850 into your margin brokerage account to act as collateral and maintain $3,500 thereafter for the life of the contract. At the end of each trading day, your profits or losses are applied to your account. Since you are the contract seller, you profit from lower prices. If prices rise and your balance falls below the $3,500 maintenance margin level, you must infuse more cash into the account. You can close the contract anytime by offsetting it with the purchase of an identical contract.
- Buy and Hedge: The Five Iron Rules for Investing Over the Long Term; Jay Pestrichelli, Wayne Ferbert
- Hedging Market Exposures: Identifying and Managing Market Risks; Oleg V. Bychuk, Brian Haughey
- Trade Like a Hedge Fund: 20 Successful Uncorrelated Strategies and Techniques to Winning Profits; James Altucher
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