Hedging Stocks Using Futures and Options

April 2, 2010

For those that have downside exposure in 401K investments in equities, or for investors that are simply long stock markets (Dow Jones, S&P, Russell or NASDAQ), using hedging techniques to protect these investments from unpredictable events is highly recommended.

Investors that are long equities can hedge their portfolios by combining equity index options and equity index futures. This is accomplished by purchasing call options and selling futures. It can be difficult to choose the ideal hedging strategy – using this example, we are selling futures and buying calls. We derive our strategy by using options modeling software.

Computer models provide invaluable analytical information that can graphically depict the best type of hedge strategy for a given investor’s tolerance for risk.

The image below, created by sophisticated option pricing software, depicts a position with a maximum loss of $500 per spread (give or take a few dollars for transaction fees). Note that a severe downturn in equity prices could produce considerable profits through use of the hedge and partially or totally offset losses in equity holdings. The hedge has a limited loss profile and an unlimited reward profile.

The dollar amount of the hedge will be a reflection of the investor’s opinion or outlook of the market.

hedge against fall in equity prices

Hedge against a decline in stock prices

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