Find out the main problem with hedging your stock or portfolio using futures.
Futures trading can be used for two main purposes; Speculation and Hedging. While most retail traders get involved in futures trading for the purpose of leveraged speculation, it cannot be forgotten that the true purpose of futures contracts is for the purpose of hedging.
Hedging using futures is technique most professional money managers use. However, there is one main problem with hedging using futures and that is the fact that the settlement price of futures contracts isn’t the actual spot price of their underlying asset. That’s right. In other words, the price basis used by futures contracts isn’t the actual price of the underlying asset but a price derived from the actual price known as the “Settlement Price”. The problem with settlement price is that it can vary significantly from the actual price of the underlying asset and this difference in pricing may cause problems with hedging using futures contracts.
Settlement price is determined at the end of each trading day or trading period by various methods, including price averaging across a certain period and reflects the future price expectation of the underlying asset at various expiration months. This is why futures contracts of different months have a different price even though they are all based on the same underlying asset.
As a result, it is nearly impossible to hedge a position to delta neutrality completely using futures.
This is also why options are becoming the new favorite hedging instrument of professional portfolio managers and are used much more commonly in stock hedging than their single stock futures counterpart.
Options base their price on the actual price of the underlying asset itself instead of a derived price of the underlying asset. As such, options are capable of the precise level of hedging that futures are not quite capable of.
Traditionally, futures contracts have been used for price protection between buyers and sellers of a particular commodity. By entering into a contract to trade the commodity at a specific price right now, buyers are protected against price hikes and sellers are protected against price drops. This is the hedging function that exchange traded futures still perform but the fact that the settlement price of a futures contract only converges with the spot price of the actual underlying asset close to or on expiration date itself, it is hard to use futures for precise short term hedging that may last only days and comes nowhere close to the expiration date.
Derivatives instruments such as futures and options are originally designed as hedging tools. As the demand for highly precise hedging over very short periods of time increases, futures are slowly becoming less popular compared to options in terms of non-commodity hedging.
Learn more about
Options Trading and
Futures Trading.
Steven Loeb