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Index Futures and Hedging

Futures First Academy
March 9, 2022
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12 minutes read
Index Futures and Hedging

In our previous articles, we explored various aspects related to index futures including index arbitrage. In this article, we explore another possible use of an index future namely hedging.

As global stock markets have skyrocketed since the deepest trough of the pandemic, the internet is flushed with articles citing overvaluations and bubbles. So, this is a good time to talk about how to use index futures for a portfolio hedge.

A portfolio, simply, is a mix of various stocks bought by a certain person in different proportions depending on the mandate or the objective of such person.

Before we jump into hedging methods, let us look at what hedging means. To put it simply, hedging means limiting or eliminating risk. In the context of investment in equity markets, hedging means limiting or eliminating the risk of a fall in the prices. The primary motivation for hedging comes from the fact that movement in equity markets are difficult to predict and that the possibility that a sell-off may start when it is least expected.

A hedge can be perfect or imperfect. Most of the hedges practically deployed in the real world are imperfect, mainly because they are much easier to construct, monitor and execute.

Perfect Hedge

Let us start with a simple example. The investor in our example bought 1000 shares each in the following companies on 3 Apr 2020: 

  1. Birchcliff Energy
  2. Endeavour Silver
  3. Timbercreek Financial
  4. Rogers Sugar
  5. Abitibi Royalties

Clearly, this investor has a high-risk appetite and has chosen to invest in the small cap segment of the market, hoping to gain from the slump during the worst part of the pandemic. As on 4 January 2022, her portfolio of equal weights has gained an impressive 112% as indicated in the following table.

Now, a 1% adverse move would result in a loss of C$ 7,068 in the portfolio. At the same time, assuming the current value of SXF at 1200, a 1% move in the S&P/TSX 60 Index  would be worth C$ 2,400 (i.e., 1% of 1200 * C$ 200). The change in portfolio is approximately three times the change in one SXF futures value for a 1% move. So, the investor can hedge her portfolio by selling three contracts of SXF futures. This is a full hedge as the gains of the investor will fully lock-in on the date of the hedge. Another option that the investor has is to do a partial hedge. For example, instead of selling three contracts, she could choose to sell, for example, one contract. This way, if the market goes down, some but not all of her losses will be recouped by the gains made on the one futures contract. But, if the market goes up, the two futures contracts which she has not used could still give her some gains. This largely depends on investor’s conviction about the market top.

In this example, we are assuming that a 1% move in these stocks will correspond to a 1% move in SXF futures. That may not be the case as small cap stocks generally tend to be more volatile than the broader market. The following tables acknowledge this possibility and summarize the above two scenarios: –

 

Scenario 1 (Full Hedge)
Portfolio 3 SXF Futures
Original Value C$ 70,680 1200
Price after 1-month C$ 80,800 1215
Profit (Points) C$ 10,120 -15 points
Profit C$ 10,120 – C$ 9000
Net Profit C$ 1,120

 

Scenario 2 (Partial Hedge)
Portfolio 1 SXF Futures
Original Value C$ 70,680 1200
Price after 1-month C$ 80,800 1215
Profit (Points) C$ 10,120 -15 points
Profit C$ 10,120 – C$ 3000
Net Profit C$ 7,120

 

So, using index futures to construct a portfolio hedge is easy, doesn’t incur costs associated with liquidity risk and provides flexibility to deploy a full or a partial hedge. Despite being an imperfect hedge, many investors choose to focus on the above merits and regularly use index futures to execute a hedging transaction, especially when they start fearing the possibility of a sell-off.

 

Company 3 Apr 2020 4 Jan 2022
Birchcliff Energy C$ 0.90 C$ 6.45
Endeavour Silver C$ 1.20 C$ 4.17
Timbercreek Financial C$ 6.96 C$ 9.58
Rogers Sugar C$ 4.23 C$ 5.97
Medical Facilities Corp. C$ 3.37 C$ 9.17

 

Now, she is concerned about the spread of the Omicron variant and fears that a downfall could claw back her gains. A perfect hedge would involve her selling such a number of futures contracts that equates the shares bought for each of the companies. After such a hedge is constructed and executed, if the market goes down, she will lose on her shares but she will gain an equivalent amount on her futures position. The perfect hedge clearly protects her from a downfall. But, what if the market continues to go up? She will gain on her shares but will lose an equivalent amount on her futures position. It means this perfect and complete hedge locks her in this position. In other words, her gains of 112% are locked-in on the date on which the hedge is executed, i.e., 4 January 2022 in our example.

But locking-in is not the major problem here. Constructing this hedge is. You cannot find exactly the same futures contracts. Even if you do, it is not necessary that all of them are liquid enough. Also, their contract size might be such that no number of contracts will ever result in an equivalent number of shares bought by the investor. The best bet in this case would be to go to a dealer and get this hedge constructed, a costly affair.

Portfolio Hedge

Let us now turn towards imperfect but practical hedges. Let us continue with the same example. For imperfect hedges, we look for the hedges that are easier to construct and have no liquidity risk. In the landscape of the stock market, an index future fits this bill effortlessly.

So, for our example, we construct a hedge using the S&P/TSX 60 Index* Standard Futures (SXF™) on TMX exchange. Each contract of SXF is C$200 times the futures contract value. This means a single point move in the index is worth C$200. Assuming that the investor has bought 2000 shares of each of the above five companies, her portfolio is worth C$ 70,680 on 4 January 2022.

 

Disclaimer 

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

Copyright © 2021 Bourse de Montreal Inc. All rights reserved. Do not copy, distribute, sell or modify this document without Bourse de Montreal Inc.’s prior written consent.  This information is provided for information purposes only. The views, opinions and advice provided in this article reflect those of the individual author. This article is not endorsed by TMX Group or its affiliated companies.  Neither TMX Group Limited nor any of its affiliated companies guarantees the completeness of the information contained in this article, and we are not responsible for any errors or omissions in or your use of, or reliance on, the information.  This article is not intended to provide legal, accounting, tax, investment, financial or other advice and should not be relied upon for such advice.  The information provided is not an invitation to purchase securities listed on Toronto Stock Exchange, TSX Venture Exchange and/or Montreal Exchange.  TMX Group and its affiliated companies do not endorse or recommend any securities referenced in this publication.

 Montreal Exchange,MX and SXF are the trademarks of Bourse de Montréal Inc. TMX, the TMX design, The Future is Yours to See., and Voir le futur. Réaliser l’avenir. are the trademarks of TSX Inc. and are used under license.  All other trademarks used herein are the property of their respective owners.

* The S&P/TSX 60 Index (the “Index”) is the product of S&P Dow Jones Indices LLC or its affiliates (“SPDJI”) and TSX Inc. (“TSX”). Standard & Poor’s® and S&P® are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”); and TSX® is a registered trademark of TSX. SPDJI, Dow Jones, S&P, their respective affiliates and TSX do not sponsor, endorse, sell or promote any products based on the Index and none of such parties make any representation regarding the advisability of investing in such product(s) nor do they have any liability for any errors, omissions or interruptions of the Index or any data related thereto.

Futures First provides market analysis services in various futures and options products across all asset classes, including fixed income, commodities, equity, and energy products. Futures First Academy is the educational arm of Hertshten Group, through our programs we have trained over 2000 students and are associated with more than 15+ Universities. Our goal is to provide academic solutions and educate people, in order to create opportunities and change lives. We achieve this by sharing our vast market knowledge, experience, access to live trading environments and training by industry expert educators.

Futures First Academy
Futures First Academy

Futures First Academy

Futures First provides market analysis services in various futures and options products across all asset classes, including fixed income, commodities, equity, and energy products. We operate nearly twenty-four hours a day. Our offices wake up with Japan and Australia, and close with US, Canada and Brazil. Our edge in the market comes from our highly trained professionals who can make quick and calculated decisions under pressure. We develop in-house technological tools, to analyse markets and identify opportunities by using advanced methods of pattern recognition. Our employees are passionate about using technology to enhance their working environment and hence thrive in our company.

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