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Dan McMullin
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Single-Stock Futures – A Simpler Hedge Than Options
Let’s examine some of the differences between single-stock futures and equity
options to find out why single-stock futures can be a simpler hedge than
options. Details about single-stock futures can be found in the Stock Futures
Zone at
Lind-Waldock.
What Is Hedging?
Hedging is the process of offsetting the price risks inherent in any cash market
position by taking an equal but opposite position in the futures market. It’s
the classic economic purpose of commodity futures. Now the same benefits can be
enjoyed by stock investors.
Imagine you’re a farmer with crops to harvest. Exposed to the chance that prices
will drop in the coming weeks or months, it’s a simple matter for you to protect
yourself by selling the appropriate futures contract. Any losses from having to
sell your crop later at a lower price can be offset by profits from the hedge.
And, so it is if you’re a stock investor. You own stocks or mutual funds just as
the farmer owns a crop. From time to time, you worry about your stocks falling
in price and want to hedge your investment.
Hedging stocks involves placing a trade that is the opposite of an existing
stock position. Single-stock futures can provide a more effective hedge than
equity options.
Why Hedge?
First and foremost, a hedge neutralizes the risk of the existing position. For
example, if you own Amgen stock, you can sell Amgen futures as a hedge against
the position. Any losses from stocks dropping in price may be offset by
potential profits from the short futures position, or the hedge.
Second, the hedge allows you to leave the original stock position in place. This
means that even though you are no longer exposed to losses, you have avoided a
taxable sale on that stock.
Third, you maintain ownership rights, continue to receive dividends, and retain
voting rights and the other privileges of owning the stock.
Finally, a hedge once placed does not obligate you to keep it on. In fact, a
single-stock futures hedge can be removed or replaced repeatedly.
How To Hedge Stock
To hedge ownership of stock, you would simply sell single-stock futures
contracts of that stock. The amount of protection received depends upon how many
single-stock futures contracts you sell.
Each single-stock futures contract is for 100 shares of stock. So selling 25
single-stock futures contracts would protect 2,500 shares. If you own 2,500
shares of stock but sell only 20 single-stock futures contracts then you’re
still net long 500 shares.
A Simpler Hedge Than Options
The effectiveness of an equity options hedge depends on several factors,
including strike price and time to expiration. The cost of an options hedge is
the premium paid, which of course is a wasting asset. The break-even point on
buying a put for protection is the strike price minus the cost of the option, so
an investor can lose money even if prices don’t move.
Single-stock futures, on the other hand, provide a near 100 percent perfect
hedge. You don’t have to worry about rates of decay or about picking the right
strike price. The break-even point of the single-stock futures hedge is simply
the price at which you sell the single-stock futures contract.
The cost of the single-stock futures hedge is the modest cash flow required to
maintain margin. Single-stock futures are not a wasting asset in the same sense
as options, and tend to move dollar-for-dollar with the underlying stock.
For these reasons and others, single-stock futures offer a cleaner hedge than
options for flexible and effective hedging of stocks.
Think of Single-Stock Futures First
Single-stock futures provide simple and effective protection against negative
moves in the underlying stock market. The original investment stays in place
while the risk of owning stock is neutralized and dividends continue.
Investors can now protect themselves with hedging strategies that were
previously only used by large, institutional traders. When you decide you might
benefit from using a hedge, single-stock futures should be one of the first
things that come to mind.
Security futures are not suitable for all customers. Before investing in a
securities futures product, you should contact Lind-Waldock, a division of Refco,
LLC, at 800-445-2000 to obtain a copy of the required security futures products
risk disclosure statement. There is a substantial risk of loss in trading
futures and options. May 2003. |
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