To hedge against market uncertainties, investors usually purchase assets that are negatively correlated to their portfolio’s most exposed ones. Then, if the sensitive asset experiences an adverse price movement, the inversely associated security should move in the other direction, functioning as a hedge against potential losses.
Derivatives are financial products that certain investors purchase to accomplish this. For an investor seeking to hedge against the risks of a fluctuating market, futures and options provide insulation from future price volatility. In other words, they provide much-needed price stability in volatile situations.
A futures contract, as a reminder, is a contract whose value is derived from an underlying asset, such as a stock, bond, or traditional index (i.e., derivatives). It is a legally binding agreement to acquire or sell an asset at a pre-set price at a future date. The buyer must buy the asset on that specified day, and the seller must sell the underlying asset at the agreed-upon price, regardless of the market price on the contract’s expiration date.
How to Use Futures to Hedge
When used as part of a hedging strategy, futures contracts lower the risk of incurring a loss due to a decline in the market value of the underlying. Therefore, the more volatile the underlying asset, the more meaningful the futures contract.
We distinguish two types of hedging with futures contracts, namely short and long hedges. Their use is determined by the investor’s objective: A long position covers a future increase in the underlying’s value, while a short position anticipates a value decline.
An investor wants to purchase barrels of crude oil in the coming year. Let’s assume that the current market price is $90 per barrel, and the price of a futures contract is $88 per barrel. By purchasing the futures contract, he locks in the price of the commodity at $88 per barrel, thereby hedging against any future price increases. However, if the price of the barrel falls, he will be bound to buy oil at the price higher than the market price.
Conversely, an investor planning to sell barrels of crude oil in the future might consider taking a short position in a futures contract if he expects the price per barrel to decline.
Taking the same fictional market price as above ($90), he could agree to lock in a sale price of $88, with execution at a given time. And at that moment, if the commodity was trading below $88, he would have successfully hedged against the market decline.
Hence, in a market crash scenario, the short position in a futures contract is an effective hedging instrument.
Options, like futures contracts, allow investors to buy (call option) or sell (put option) an asset at a predetermined price within a certain time period. The main distinction between options and futures is that an option holder is not compelled to buy or sell the underlying asset if he chooses not to, whereas a futures contract holder is obligated to buy or sell the underlying asset if it is held until settlement. It simply gives the holder the right to do so.
How to Use Options to Hedge
For example, an investor has a specific position in his portfolio that he believes is in jeopardy due to the present market environment. By pairing a put option with this position, he can ensure that he will be able to sell it at a predetermined price and within a predetermined time frame, thus hedging against a potential market downturn.
- If, during this period, the value of the position eventually rises, he will not be able to exercise his put option. However, he will have lost only the premium he paid for the put option, and his underlying position will have increased.
- On the other hand, if the value of the position collapses, he will be able to exercise the option and sell the position above the market value, which will significantly reduce his losses.
Covid-19: Futures and options markets developments
The Covid-19 outbreak, and subsequent pandemic spread, had a significant adverse impact on global financial markets. As retail and institutional investors hastened to portfolio hedging components, the derivatives markets for exchange-traded futures and options surged.
In the first quarter of 2020, investors heavily relied on futures and options to hedge their positions, endangered by the then-increased unpredictability of the global pandemic. Accordingly, derivatives trading has grown in practically all contract types and in all locations, totaling a 58.82% increase year-on-year.
During the same period, single stock futures volumes increased by 56.26% (YoY), while single stock futures volumes were up by 39.60% (YoY).
The Bottom Line
In summary, the primary advantage of futures and options contracts for investors is that they remove uncertainty about a commodity, security, or another financial instrument’s future price – Having the ability to lock in an asset price regardless of the market’s outlook can provide a sense of security.
Nevertheless, investors should keep in mind that hedging stocks require the payment of premiums, the cost of which is influenced by several factors, including the current price of the underlying instrument, the strike price, the current interest rate, the expiration period, expected dividends, and predicted volatility.
Furthermore, any well-diversified portfolio often includes dozens of positions among several asset classes. And in the event of a market downturn, investors often seek to hedge not just one or two positions but the majority (if not all) of their portfolio, which can quickly become highly expensive.
However, if you’re looking for security in your portfolio and limiting a tail-risk market event, futures and options are excellent ways to hedge against uncertainty.
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