Hedging a portfolio with futures or CFD’s formula

Hedging a portfolio with futures or CFD’s formula20.04.2015


Hedging your holdings has never been so easy. With the explained formula you will be able to follow multiple assets and simply view the hedging possibilities. The classic hedging is based on using Futures contracts on a regulated exchange while for shorter periods and swift actions, CFD’s can be recruited for the task as well.

Hedging definition is: “To prevent or hinder free movement” . In finance we use hedging in order to lock down a gained profit for a certain period of time i.e. removing the risk of volatility.

The classic example: An exporter is offering his buyer a 30 days credit. The exporter is producing his merchandise in US, i.e. his costs are in $$. The invoice is issued in €€ at the exchange rate on the day of invoice. Now, during the 30 days, the €/$ exchange rate may vary causing financing gains or losses. In order to remove the offsets, the exporter can initiate a sell position for the equivalent amount of €, making sure that the same amount of $$ will be received after 30 days.

In figures: On Jan the 1st the exporter ships items for the value of EUR 125000. On Jan the 1st the EUR/USD is at 1.138, meaning value of USD 142250. On Feb the 1st, the payment is done but the exchange rate for EUR/USD is at 1.134, meaning that the exporter has received USD 141750, marking a USD 500 loss.

If on Jan the 1st the exporter would initiate a sell or short position on the EUR, he would cover the loss.

One future contract of EUR/USD consists of 125000 trading units, meaning EUR 125000. Opening a sell position on EUR/USD at 1.138 would bring the exporter a USD 500 profit preventing the loss from the price change during the 30 days of credit. He would be in the same position if the EUR/USD rate was at 1.142. He would gain USD 500 from the selling of EUR but losing USD 500 on the Future Sell position.

How can we use hedging in our personal life? Suppose I am holding a stocks portfolio as part of my retirement plan. Most people do. I believe that the stock market is going to suffer some corrections due to bad unemployment and credit reports. I have already marked a profit and I do not wish to lose it and neither to liquidate my holdings. I can open a selling position for my holdings and this way locking my profit. 

When you are a professional trader, you may notice price differences that you can lock.

 

Starting from a shares holding position, we buy 1000 shares for $2 each. Here is the graph of shares holding:

 Graphic holding of shares

Point  a is the buying value. If the price rises to $3 (b), we would generate $1000 profit. If the company turns belly up, the share value drops to 0 and as seen in point c the loss will be of $2000. From looking at the graph it’s easy to interpret where we stand at each market value. Please note that in reality you should calculate the commissions as well. If buying $2000 shares would carry a 0.5% commission, the breakeven point would be at $2.005

Selling a future contract with a strike price of $4 and 1000 trading units would look like that:

Graphic future holding 

If the market price would move to $5 (c), we would lose $1000. Of course during the lifetime you would have only to deposit margin, the final calculation will take place on the expiry date.

If the share price would decrease to $2 we would generate $2000 profit.

Please note that commissions and lost alternative rate weren’t calculated.

Now, holding both together:

 Futures hedging graphic

From holding 1000 shares bought at $2 and selling one future contract (1000 trading units) for $4 you lock down a $2000 profit in any market situation. If the share price moves to $5 the strategy would generate $1000 loss on the future holding and $3000 profit from the shares holding leaving you with $2000 profit. If the market moves to $1 the future will generate $3000 profit and the shares $1000 loss, again leaving $2000.

Note that commissions weren’t calculated here. Such a spread is non-existent in reality, it is just an example.

The following formula lets you calculate the profit over a certain period of time, taking in mind commissions and margin costs.

 

Portfolio hedging formula 

 

nS: nSpot – nr of shares

cF: Future Commission

xF: Future Strike Price

rA: Alternative rate

xS: Spot Price

M: Margin

cS: Spot Commission

r: %profit

 

* For Stocks use the Ask and for the Future use the Bid

* rA: The alternative rate is the interest rate on a savings account that you’d lose if used for margin.

* Note that you need the same number of shares as per trading units of the Future. If one Future is for 100 shares, you need 100 shares for each future contract.

* Fluctuations may occur. The stocks commission is the same for buying and selling although it is a percentage from the value that may not be the same. The rA also varies as the margin varies.

The downside of futures is the size of it. You may not use fractions. If you are already holding 85 shares and the future is for 100 trading units, you are exposed for the equivalence of 15 shares. CFD’s can be a short term solution and can be used at any size. In order to recruit CFD’s for such a task you need to calculate the overnight commsission.

Another difference between CFD’s and Futures is that CFD’s do not have a strike price. You open the position on the quoted price. CFD’s may be used to lock down already made profits from the shares holding.

Under no circumstances try to trade leveraged products without the proper knowledge.

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