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Learn the Basics of Risk Management
Risk management is the number one focus of a successful trader - it is the essence of managing your capital to prevent losing it and giving back gains in a position.
RJO Futures wants you to know as much as you can about how to apply risk management techniques to futures trading.
Our complimentary guide, "The Basics of Risk Management" will help you learn essential principles and more, including fundamental steps in the process of managing risk within your trading plan.
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Today's Featured Article
With the collapse of the equity markets in 2008 and subsequent uncertainty as we close out 2009, individual investors are increasingly looking for ways to protect their portfolios. One way is to hedge your portfolio using futures and options on futures.
Hedging Basics
Hedging is a risk reduction strategy in which investors and traders take off-setting positions in an instrument to reduce their risk profile. Basically, as the value of your assets fall, the value of the hedge increases, therefore offsetting these losses.
A simpler way to view hedging is the act of protecting your assets from negative outcomes by passing on the risk to another party. Investors understand the need to protect their physical assets, such as cars and houses, with theft and fire insurance and/or to protect their future earnings with life and disability insurance. In these instances, an individual is passing on the risk of loss to an insurance company.
In markets a hedge is an investment that is used specifically to reduce or cancel the risk in another investment. Therefore, if you are long an investment (i.e. you want the price to go up) you need to add a different investment to your portfolio that will appreciate in value as the price of your existing investments decrease. A perfect hedge would match any price losses to the upside with equivalent price gains to the downside. For example, if your portfolio were to experience a loss of $95,000 over a three-month period you would want to have hedged the portfolio with a security or instrument that provided a gain of $95,000 over the same time horizon.
There are many different ways to hedge an investment portfolio depending on the portfolio's composition and the investor's time scale and earnings expectations. However, futures contracts (and options contracts) are the most common financial instruments to hedge investment risk.
Note: Hedging should not be confused with diversification. With diversification, risks are uncorrelated. With hedging, they have negative correlations. Correlation is the reciprocal relation between two or more things. In the case of hedging, a negative correlation means that as market factors cause the value of one investment to increase, the same factors cause the negatively correlated investment decrease in value.
The ultimate goal of an investor using futures contracts to hedge their portfolio is to perfectly offset their risk. However, it is difficult to get an exact match between the portfolio and the hedge and therefore a good hedge is one that has the highest correlation -- closest to one -- and closest time horizon.
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Hedging with the S&P 500 Index
For example, the S&P 500 index is one of the most widely-traded index futures contracts in the world. However, the 500 companies that make up the index may not be representative of the investor's portfolio. The companies in the S&P index represent the 500 largest companies in the U.S. Therefore, if an investor has a large percentage of small-cap or medium-sized companies in their portfolios, you may want to use the S&P Mid-Cap 400 index to hedge your portfolio.
Below is a table of index equity futures that can be used to hedge an equity portfolio:
Equity Index
| Description | | S&P 500 | 500 U.S. stocks with the largest market capitalizations |
| Dow Jones Industrial | 30 of the largest and most widely held public companies in the U.S. | Nasdaq 100
|
100 of the largest domestic and international non-financial companies listed on the NASDAQ stock exchange | Russell 1000
(Regular)
| 1000 of the largest companies in the U.S. and represents approximately 92% of the U.S. market | Russell 1000
(Growth)
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1000 of the largest companies with higher price-to-book ratios and higher forecasted growth values | Russell 1000
(Value)
| 1000 of the largest companies with lower price-to-book ratios and lower expected growth values | Russell 2000
(Regular) |
2000 of the smallest companies in the U.S. | Russell 2000
(Growth)
| 2000 of the smallest companies with higher price-to-value ratios and higher forecasted growth values | Russell 2000
(Value) |
2000 of the smallest companies with lower price-to-value ratios and lower forecasted growth value | | Russell 3000 | The Russell 3000 Index measures the performance of the largest 3000
U.S. companies representing approximately 98% of the investable U.S.
equity market. |
Perhaps your investment advisor suggests that the fourth quarter of 2009 will bring a downturn in equities and your portfolio should be protected. If you believe this is possible, you can either liquidate your portfolio of mutual funds and individual stocks, or keep the existing securities and hedge with futures to limit possible losses and lock in any gains you may have incurred
You may decide you will not liquidate your portfolio due to these reasons:
- Money market accounts yield 1.00%
- You might incur a taxable capital gain for the year
- Your mutual funds may have an exit penalty and/or re-entry fee
- There is a possibility that the market is only temporarily down, and may bounce back
Therefore, you decide to hedge the risk that your portfolio will lower in value at the beginning of the following year. In addition, a review of your portfolio's performance indicates that it has a correlation of 1.0 to the S&P 500 index. This implies that for every 1%, the S&P 500 index moves up or down, your portfolio will move in synch by 1.0%.
After deciding what you want to hedge, you need to calculate how many contracts are necessary to short in order to protect your portfolio.
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Hedge Information
Starting Portfolio Value: $225,000
Correlation: 1.0
Outlook: Short term bearish... looking for a decline of at least 10% - 15%.
Time Frame: 10/01/09 - 03/15/10
Strategy: Sell 3 E-mini S&P 500 futures contracts to hedge portfolio.
To implement this hedge we need to calculate how many contracts we need to short in order to protect your portfolio. The contract specifications for the S&P 500 and its smaller cousin the E-mini S&P 500 are shown below.
Equity Index
| Contract Size |
Tick Size | $ Value on
Oct 1st, 2009 | | S&P 500 | $250 x E-mini
S&P 500 futures price | 0.10 index points
= $25 | $250 x 1,022.80
= $255,700 | E-mini S&P 500
| $ 50 x E-mini
S&P 500 futures price | 0.25 index points
= $12.50 |
$ 50 x 1,022.75
= $51,137 |
The regular S&P 500 contract is too large to use, therefore, we will use the E-mini S&P 500 contract.
Calculate how many contracts are needed to hedge portfolio:
Value of portfolio = $225,000
Value of 1 E-mini S&P 500 contract = $51,137
$225,000 / $51,137 = 4.39 contracts or 4
 If you cannnot view the example,
go here.
With the current uncertainty of equity markets and with no clear upside in sight, it is beneficial to take a look at the many ways to protect your portfolio. One of these options that has the potential for success is hedging with the futures market. For more information on how to use these tools, contact any of our Senior Trading Advisors directly at 800-441-1616 or 312-373-5478. Or email them at
info@rjofutures.com.
Disclaimer: The risk of loss in trading commodity futures and options is substantial. Before trading, you should carefully consider your financial position to determine if futures trading is appropriate. When trading futures and/or options, it is possible to lose more than the full value of your account. All funds committed should be risk capital. Past performance is not necessarily indicative of future results.
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About the Author
When it comes to futures trading, RJO Futures
believes that the more information you have, the better trading decisions you will make. That is why we are committed to making our knowledge and advice available to traders of all skill levels. Whether you are interested in a full-service account or are a self-directed trader, we can keep you informed via emails, our trade recommendations hotline, educational guides, or in direct conversations with one of our advisors. Start including our advice in your decisions today: contact any of our Senior Trading Advisors directly at 800-441-1616 or 312-373-5478. Or email them at
info@rjofutures.com.
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Special Message from Our Author
Learn the Basics of Risk Management
Risk management is the number one focus of a successful trader - it is the essence of managing your capital to prevent losing it and giving back gains in a position.
RJO Futures wants you to know as much as you can about how to apply risk management techniques to futures trading.
Our complimentary guide, "The Basics of Risk Management" will help you learn essential principles and more, including fundamental steps in the process of managing risk within your trading plan.
Get your complimentary copy of "The Basics of Risk Management". |
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