Basic Futures Strategies for Value Investors

Futures allow for directional bets on a commodity with huge leverage usually between 10:1 and 20:1 which implies either winning big or losing big. Trading in the futures markets are controlled by hedgers and speculators. Rather than speculating with futures, value investors use them as a hedging tool and in the context of their overall portfolio, there are numerous ways to use futures as a hedging tool:

Buying stock index futures: Purchasing stock index futures on a representative index (S&P 500) allows placing a large long bet on the overall market. The approach can be beneficial for a value investor, whose research indicates oversold market conditions. While purchasing stock index futures is similar to buying a call on the index concerned the significant differences are:

1. With a long call option, the maximum loss is when the option expires worthless as the index stayed below the strike price plus call premium. The actual loss will then be the premium paid or simply put; the downside is capped at the call premium. The upside has no limit. 
2. With a long futures contract, the maximum loss is the total contract value, which can vary between 10 and 20 times the initial margin. Even though the maximum loss scenario is unlikely (i.e.the index goes to zero), the downside is relatively huge. The upside is not bounded. Given the large leverage involved, it is best to consider long futures contracts as though one has established a long position on the index for the total contract value. For e.g., if one E-mini S&P futures contract (one such contract stands for 50-times the value of the S&P 500 stock index. So, based on the current S&P 500 index value of 1370, one E-mini S&P futures contract has a value of 1370*50=$68,500) is purchased at a quoted price of $1370 using the initial margin requirement of $5000, then it is best to regard the stake as though one is long the S&P 500 index at $1370 for $68,500 (1370*50) – the size of the position also happens to be the size of the maximum loss. 

Long futures contracts are preferred over long call options when analysis points to the significant likelihood of the index staying just below the strike price plus call premium. Should that scenario pan out, the investor might be able to exit with small gains as opposed to a total loss of the call premium with options.

Selling stock index futures: Selling stock index futures on a representative index such as the S&P 500 allows placing a large short bet on the overall market. For a value investor, the approach is beneficial when applied after recognizing overbought market conditions. The approach is akin to buying a put on the index concerned, although there are significant differences –

1. With a long put option, the maximum loss is when the option expires worthless as the index stayed above the strike price plus call premium. The actual loss will then be the put premium or in other words, the downside is capped at the put premium. The upside is limited to the value of the underlying shares at the strike price minus the put premium.
2. With a short futures contract, the potential loss is unlimited. Losses rise proportionally to the increase of the index above the price at which it was sold. The upside is limited to the total contract value as the index cannot fall below zero. Because of the leverage involved, it is best to view short futures contracts as though one has established a short position on the index for the total contract value. For e.g., if one Mini S&P 500 Futures Contract is sold at a quoted price of 1250 using the initial margin requirement of $5000, then it is best to regard the stake as though one is short S&P 500 index at 1250 for $62500 (1250 * 50) – the size of the position.

Short futures contracts are preferred over long put options when analysis points to the significant likelihood of the index staying just above the strike price plus call premium. Under such a scenario, the investor might be able to exit with small gains instead of a total loss of the put premium with options.

It is also possible to buy or sell commodity index futures on individual commodities in a similar fashion. But, value investors should base their hedging strategies on a bottom-up analysis on the commodity involved and should also come up with a valuation at specific dates. The macro environment needs careful analysis before committing capital. 

Related Posts:

• Cash holdings in an investment portfolio - strategies to squeeze income for value investors
• Kelly Criterion based Strategies for Value Investing
• Covered Call Strategy for Stable Income Portfolio
• Basics of Options and Futures for Value Investors
• Basic Options Strategies for Value Investors
• Basic Futures Strategies for Value Investors
• Short Selling Strategy for Value Investors

Last Updated: 04/2012.