Hedging involves using derivative financial products to protect a portfolio against a short-term market decline. Stock-index futures are an appropriate choice to hedge a diversified stock portfolio against an expected loss. A well placed hedge will gain value at the same rate the hedged portion of your stock portfolio loses value.
1. Determine what percentage of your portfolio you want to hedge. Hedging prevents losses but also any stock-market gains will be offset by losses on the hedge. For example, if you have a $2 million stock portfolio, you may want to cover 75 percent, or $1.5 million, with hedges.
2. Select the futures contract that follows the stock index that best matches the composition of your stock portfolio. Futures trade against these stock indexes: S&P; 500 Dow Jones Industrial Average S&P; Midcap 400 S&P; Smallcap 600 Nasdaq 100 S&P; 500 Growth S&P; 500 Value Russell 2000
3. Calculate the value of one futures contract at the current index price. Futures are valued at a multiple of the index. For example, the S&P; 500 futures contract is valued at 250 times the S&P; 500 stock index. If the S&P; 500 is at 1,200 one futures contract is worth $300,000.
4. Calculate the number of futures contracts to sell short to cover the value of portfolio you want to hedge. Using the example of $1.5 million to hedge and one futures contract is worth $300,000, five S&P; 500 futures contracts will provide a sufficient hedge.
5. Place an order to sell the calculated number of stock-index futures with a registered commodity-futures broker. A futures trade can be opened with either a buy or sell order. Sold futures positions will increase in value if the tracked stock index declines in value. The broker will require a margin deposit for each contract traded. At the time of publication, for example, the margin deposit for a S&P; 500 futures contract was $25,000.
6. Monitor the value of the stock market and the sold index futures. If the stock market drops, the futures position will gain in value at the same rate as the stock-market decline. An order to buy the futures contracts will close the position and lock in any profits.
- Stock-index futures contracts have monthly expiration so you can pick an expiration date coinciding with your expectation concerning the time frame of the market decline.
- E-mini versions of the stock index futures have smaller contract values and margin-deposit requirements. For example, the e-mini S&P; 500 contract is one-fifth the size as the regular S&P; 500 contract. Use e-mini contracts to hedge a smaller portfolio or fine-tune the size of stock portfolio to be protected with a hedge.
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