Hedging - a guide to reducing portfolio risk Hedging - a guide to reducing portfolio risk Hedging - a guide to reducing portfolio risk

Hedging - a guide to reducing portfolio risk

peter-siks
Peter Siks

Summary:  Hedging is a risk management strategy that can be used to protect individual positions or your whole portfolio. It involves creating a position that will move in the opposite direction of the initial position and (temporarily) reduce your risk. This can help to give piece of mind during periods of uncertainty, without the need to (partly) liquidate your holdings.


Hedging, explained

Hedging a portfolio (or position) means taking an opposite position that reduces the risk of the portfolio. An appealing example is the hedging of currency risk. Suppose a European company knows that in six months it will receive a delivery worth USD 5 million that will have to be paid in USD. In addition, they are satisfied with the current exchange rate of the EUR/USD and can make their cost price calculation on it. By entering a dollar contract which fixes the EUR/USD price in six months, they have hedged their currency risk. Whether the price of the EUR/USD is going up or down does not really matter to them anymore.

When hedging a position, the hedger will search for a product that moves exactly in the opposite direction of the underlying asset.  If one rises, the other falls and vice versa.  A fully hedged position will therefore have (virtually) no downside risk but also (virtually) no upside potential as the positions, theoretically would even each other out.

Hedging open positions is something that happens continuously in the professional trading world. For many private investors, this is often a bridge too far because they deal with risk very differently and some are unaware that hedging is a possibility. However, its worth remembering that it is possible to hedge the broader market risk of an equity portfolio – in part or in whole by using derivatives such as futures on the relevant index. But there are a number of things that you should take into account:

  • The complexity of your investment portfolio increases. You may, for instance, have to deal with margin

  • There are costs associated with maintaining the hedge. Think of possible interest costs, the spread, the transaction costs and possible roll-over costs

  • The upside potential has (largely) disappeared due to the holding of a short future on the index

  • The portfolio must be (very) well correlated with the index on which you take the future position

  • A portfolio consisting of a very limited number of stocks may, under normal circumstances, correlate well with the index (on which futures are available). However, a sharp decline in one of the stocks in the portfolio will be noticeable in the portfolio but remain invisible in the futures of the broader market (the hedge). In that case, a loss is incurred on the portfolio that is not offset by the hedge

  • The contract size of the future: a future might be "too big"

An example...

Mr. Smith has a well-diversified investment portfolio in European equities worth EUR 250,000. Now Mr. Smith and his wife are going on a three-week safari where he has no opportunity to monitor his portfolio. He could of course sell the entire portfolio, but that is not his preference. He wants to enter into a contrary transaction via futures on the EuroSTOXX50 index. He chooses the EuroSTOXX50 because it has a good correlation with his portfolio. The index level is 3,700 points.


Number of futures

How many futures does Mr. Smith have to sell short to hedge his portfolio as precisely as possible? 

The contract size of the future on the EuroSTOXX50 is 10 (you can check this in the order ticket). This means that the exposure of 1 future is EUR 37,000 (at an index level of 3,700).

A total of EUR 250,000 must be hedged and 250,000/37,000 = 6.74. When selling seven futures, he is therefore left with a small short position. If he were to sell six futures, he would have a small long position left. Mr. Smith decides to sell six futures.

Graphically, it looks like this:

Hedge Article Edit

Scenarios

1.  Sideways

In the first scenario, the market moves sideways. Both the portfolio and the hedge do not materially change in value. Upon returning from abroad, the hedged position is closed. The Smith family has in any case ensured a relaxing holiday.

2. Higher

During the period that Smith stays abroad, the index rises 5% from 3,700 to 3,885. The stock portfolio is worth 5% more and that is EUR 12,500. But how much 'loss' has been made on the hedge? The difference is also 185 (the amount the portfolio had increased) and we know that the contract size of the future is 10. In total, Mr. Smith was short six futures. The calculation then is: 185 * 10 * 6 = EUR 11,100. This means that Mr. Smith earned EUR 1,400 (12,500 11,100). Remember that, before leaving for safari, Mr. Smith’s portfolio still had a small long position because he bought six contracts, needing 6.74 to cover the entire portfolio.

3. Lower

If the index were to fall 5% to 3,515, it would cost EUR 12,500 on the portfolio side. But the future position has made money. The six futures that Smith is short can be closed 185 points lower with a profit. The calculation: 185 * 10 * 6 = EUR 11,100.  In this case, the hedge has largely worked, but because of the small long position remaining, a decline in the market has had a limited negative effect.


When to hedge

One reason to (partially) hedge a portfolio could be a stay abroad. If you have no time, no desire or no internet connection to monitor your portfolio, hedging offers a way to reduce the risk. Another reason may be that you are simply not comfortable with the current market conditions and that you are afraid of a sharp decline. Liquidating the portfolio goes too far, so (temporarily) hedging the portfolio is a very practical alternative.


Conclusion

A well-diversified portfolio can be largely hedged with a short future on a well-correlated index.  If you plan to follow this strategy, make sure you understand exactly how futures work. And don't forget to pay attention to the contract size.

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
Full disclaimer (https://www.home.saxo/legal/disclaimer/saxo-disclaimer)
Full disclaimer (https://www.home.saxo/legal/saxoselect-disclaimer/disclaimer)

Saxo Bank A/S (Headquarters)
Philip Heymans Alle 15
2900
Hellerup
Denmark

Contact Saxo

Select region

International
International

Trade responsibly
All trading carries risk. Read more. To help you understand the risks involved we have put together a series of Key Information Documents (KIDs) highlighting the risks and rewards related to each product. Read more

This website can be accessed worldwide however the information on the website is related to Saxo Bank A/S and is not specific to any entity of Saxo Bank Group. All clients will directly engage with Saxo Bank A/S and all client agreements will be entered into with Saxo Bank A/S and thus governed by Danish Law.

Apple and the Apple logo are trademarks of Apple Inc, registered in the US and other countries and regions. App Store is a service mark of Apple Inc. Google Play and the Google Play logo are trademarks of Google LLC.