Summary: Hedging is a risk management strategy that can be used to protect individual positions or your whole portfolio. It involves buying or selling a position that will move in the opposite direction of an existing position and reduce your risk. This can help to give peace of mind during periods of uncertainty, without the need to sell some or all of your holdings.
The complexity of your portfolio increases as you might now have added derivatives to the mix. These products are generally more complex than stocks and bonds and require a thorough understanding of their characteristics and risks before use. With derivatives, you may, for instance, now have to deal with margin and margin calls and have to monitor your portfolio more closely, more likely on a daily basis
There are costs associated with trading derivatives and maintaining the hedge. Those costs include interest costs, spread, transaction costs and possible roll-over costs
The upside potential is reduced or even eliminated with full hedges
The instrument used to hedge must be correlated to the existing position or the portfolio for the hedge to be effective
Because the portfolio and the index are positively correlated (i.e., they move in the same direction), the hedge position cannot be to buy the index (i.e. go long) but rather to sell the index which is to enter into a short position. When the existing position and the proposed hedge instrument are negatively correlated (i.e., they move in opposite direction), the hedge position is to go long, not short.
Now that we have established the direction of the hedge position, how many futures does Mr. Smith have to sell short to hedge his portfolio.
The contract size of the future on the EuroSTOXX50 is 10 (you can check this in the order ticket). This means that the exposure of 1 future is EUR 37,000 (at an index level of 3,700). A total of EUR 250,000 must be hedged and 250,000 / 37,000 = 6.74. When selling seven futures, he is therefore left with a small short position. If he were to sell six futures, he would have a small long position left. Let’s assume Mr. Smith decides to sell six futures (37000 * 6).
Reasons to to (partially) hedge a portfolio could be when one is off the grid (on vacation), one doesn’t have the time nor the desire to monitor a portfolio or simply one is not comfortable with the current market conditions and is afraid of a sharp decline. Liquidating the portfolio might be too much for most, so (temporarily) hedging the portfolio can be a practical alternative.
Hedging isn’t commonplace for retail investors and involves additional costs. It nonetheless has some practical uses and can help reduce some of the risk of loss. A well-diversified portfolio can be largely hedged with a short future with a well-correlated index. If you plan to follow this strategy, make sure you understand exactly how derivatives work.
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