How to Hedge With Stock Index Futures

The most important duty of a professional investment manager is to avoid losing her clients' money. For a portfolio manager, avoiding losing money requires a way to control systemic risk, which is an event-related decline in stock prices across the entire market or even a typical market correction. In 1982, stock index futures were created to allow portfolio managers to control this risk by hedging their investments using futures contracts like commodity producers hedge the value of their production..

Value Line was the first stock index future traded in 1982 on the Kansas City Board of Trade. There are other stock index futures contracts traded, but the most popular stock index futures contract is the S&P 500, which is traded on the Chicago Mercantile Exchange. The cost of stock index futures makes them difficult for average investors to take advantage of. For example, the multiplier used on S&P 500 futures contracts is $250 times the value of the index. So, if the index is at 1,000, you would pay $250,000 to buy one futures contract. This is why the S&P e-mini contract was created in 1997. Its multiplier is $50, so one futures contract if the index was at 1,000 would cost $50,000 -- much more affordable for the retail investor who wants to hedge portfolio risk.

If you own an S&P e-mini futures contract that you bought when the S&P was at 1,000, and the index rises to 1,500, the value of your contract rises from $50,000 to $75,000. If the index drops to 500, your contract's value is $25,000. The S&P contract is the most popular because the S&P index is considered reflective of the broad market, and many index mutual funds and hedge funds as well as S&P-based exchange traded funds are widely used ways of investing in the diversified broad market.

If you own $50,000 worth of an S&P-based investment, hedge by selling short (meaning you don't actually own it to sell) one S&P e-mini futures contract at $50,000.. If the S&P declines from 1,000 to 500, you would buy it back at $25,000, making $25,000 profit to cover any losses in your investment portfolio. This is a simple hedge. Other hedging strategies involve complex formulas that figure in discrepancies between the absolute value of the stock index versus the market value of the index future. Because of the demand-versus-supply nature of freely trading markets, the values often don't correlate. These small discrepancies are important to huge institutional portfolios but mean only a few dollars to an average retail-size portfolio, so individual investors typically use simple hedges.

Choose the index future that reflects your investment portfolio. For example, for a portfolio of mostly New York Stock Exchange issues, sell a NYSE Composite futures contract, traded on the New York Futures Exchange. That contract, the S&P 500 contract and the Value Line Composite Index contract are the most commonly used. Most investors sell or buy their contracts using margin provided by their brokers. Using margin, you would deposit approximately $3,500 for an S&P e-mini contract. A full S&P 500 contract margin deposit would be approximately $21,875. The multiplier can change and margin rates change frequently, depending on interest rates and Federal Reserve Monetary policy.