Looking to the Futures

Hedging A Large Cap Portfolio

May 29, 2024 Chris Waterbury
Today, I would like to discuss three different methods than can be utilized to hedge a large cap stock portfolio and provide context to the information necessary to place a proper hedge.

 Today, I would like to discuss three different methods than can be utilized to hedge a large cap stock portfolio and provide context to the information necessary to place a proper hedge.  

For the purposes of this discussion, let’s assume we are looking to hedge a $500,000 portfolio of large cap stocks using Index products that track the S&P 500. The E-mini S&P 500 or ES futures contract, SPY ETF, and $SPX options are three common products used to hedge a portfolio of large cap stocks.  

We will also discuss the importance of beta weighting your portfolio. Beta is a measurement of volatility of an individual stock in comparison to the market. The level of the beta indicates the degree of correlation between a security and a market benchmark, in this example the S&P 500. A beta greater than 1 means the stock is more volatile than the overall market, while a beta less than 1 indicates that the security is more stable than the market. To find your portfolio’s beta you will need to multiply the percentage of the stock in your portfolio by its Beta, then add up the results of each position. 

Another concept you will need to understand when hedging a portfolio is Delta. Delta measures an option's price expected rate of change compared to a $1 change in the price of the underlying security or index. For example, a Delta of 0.40 means that the option's price will theoretically move $0.40 for every $1 move in the price of the underlying stock or index. 

In order to hedge a portfolio using the E-mini S&P 500 futures contract a client will need to first have a margin account that has been approved to trade futures. For the purposes of this discussion we will assume a $500,000 portfolio of large cap stocks which has a beta of 1. At the time this article was written, the E Mini S&P 500 June 2024 (ESM24) was trading at 5330 which computed to a notional value of $266,500 (5330*$50). In order to calculate the number of contracts needed to place the hedge we will need to divide the total portfolio value by the notional value of one ESU23 contract. 

$500,000/$266,500= 1.88 ESM24 futures contracts 

Two ESM24 contracts would slightly over hedge a 500,000 portfolio of large cap stocks, providing only $533,000 of notional value protection. In order to adjust the hedge protection, a trader could use Micro E Mini S&P 500 contracts, which have 10% of the notional value of the E Mini contract at $5 per point. One MESM24 contract has a notional value of $26,650 based on current prices. If a trader wanted to more accurately hedge their portfolio they could take a short position in 1 ESM24 contract and 9 MESM24 contracts to provide a hedge with a notional value of $506,350 ((50*5330+(5*5330)*9).

 The current initial margin requirement for an ESM24 contract is $17,721.  The current initial margin requirement for an MESM24 contract is $1,772.10.  So the total cash requirement to implement this of a $500,000 portfolio of large cap stocks utilizing E Mini S&P 500 and Micro E Mini S&P 500 futures contracts would be $33,669.90.

Exchange traded funds (ETF) on broad based indices also provide hedging opportunities. We can create a hedge strategy for a $500,000 portfolio with a beta on 1 using SPY the SPDR S&P 500 ETF. In order to place a short hedge using SPY you will need a margin account. As of this writing, SPY was trading at $530.00 per share. In order to fully hedge our $500,000 portfolio we will need to sell short 943 shares of SPY at a price of $530.00 per share. The standard margin requirement of a short position of this nature is 30%, which would leave the total requirement for this hedge position at $150,000. This is a straightforward strategy that is easy to conceptualize, but fairly expensive. 

The third example that I would like to discuss is a hedge strategy using options on the S&P 500 index, ticker symbol $SPX. Using options as a hedge strategy brings in the added element of time. We will also have to factor in Delta to the equation to create a complete hedge on a $500,000 portfolio of large cap stocks. For the purposes of this discussion, I will use an at-the-money option roughly three months from expiration. The SPXW 08/16/2024 P was trading at $84.00 per contract at the time this was written with a Delta of .40. Factoring the $530,050 underlying value of the contract and the .40 delta, the hedge value of SPXW SPXW 08/16/2024 5305 P is $212,200 per contract.  

$500,000/212,200= 2.35 SPXW 08/16/2024 5305.00 P 

Two SPXW 08/16/2024 5305.00 P contracts would slightly under hedge a $500,000 portfolio and would cost $16,760 at the time this was written. When using Index options to hedge it is very important to factor in strike and expiration selection to meet the tailored needs of your portfolio. We can see that this strategy has a lower cash outlay compared to a futures hedge, however there is a reoccurring cost if you need to push the hedge out to a later expiration. Futures initial requirements are used as cash placeholders and option premiums operate as a sunk cost that requires premiums to be paid each time a hedge strategy is implemented.  

As you can see through these three examples, futures can provide excellent hedging opportunities but may not always be the best option for your trading needs. The added leverage with lower cash outlays can allow you to protect a $500,000 portfolio with an initial margin requirement of around 6.75% of the underlying value. However, this strategy does not go without risk. If the market rises you may need to deposit additional funds in your futures account in order to meet a margin call. A poorly timed hedge can result in missed opportunities and can produce losses. As volatility increases, Initial margin requirements and options premiums can increase. 

Utilizing Index based ETF’s can also require a trader to increase their cash holdings in order to maintain their position which could ultimately result in a margin balance subject to interest. Utilizing $SPX options to hedge your portfolio can be very expensive if you need to continuously roll your position in order to meet your desired hedge protection over a longer period of time.  

Utilizing the CME’s micro contract traders can use futures to hedge portfolios of nearly any size. Using broad based index ETF’s one is required to meet the 30% margin requirement which can be very expensive. When trading index based options a trader is forced to select the correct time frame as well as the correct strike price. Other benefits of hedging through futures contracts include longer trading times, with futures trading 23-hour trading days. Charles Schwab Co. Inc representatives are not tax professionals, but it is important to note that Futures contracts and $SPX option contracts are taxed as a 1256 contract, with 60% taxed as long term gains and 40% taxed as short term gains.  

We have covered a variety of ways to hedge your portfolio, ultimately it is up to each individual trader to explore different opportunities and find the most suitable strategy for their trading objectives.  

Contract Specifications

E Mini S&P 500 June 2024 (ESM24)

E Mini S&P 500 June 2024 (ESM24)

Economic Events today.

Fed's Beige Book                                        2:00 PM ET

MBA Mortgage Applications Index            7:00 AM ET