Hedging risk is an integral factor in any intelligent investment strategy. Since no one knows for sure exactly where the markets will move, who’s to say components of your equity portfolio won’t crash and burn when faced with market volatility?
In the game of beating the stock market, many will play and very few will win.
Speculating on potential gains you could achieve on certain investments really isn’t practical. What is practical, though, is assuming an opposite position in single stock futures against your current cash market security position to hedge risk you might encounter. This can be achieved in various ways, one of which is the writing or purchasing of options on single stock futures contracts.
If you’re bullish about single stocks, consider using a synthetic long call strategy. Here, the investor simultaneously assumes a long position and put option on a single stock futures position. Together, the two create a something comparable to a long call. The very attractive benefit of this move being that your maximum loss is limited to just commission plus the premium paid on the option, while your maximum gain is virtually unlimited.
Say you are very confident that the share prices of company X will rise. Instead of buying stock outright at $49 per share, which runs you the risk of loss should the market move against you, you purchase one single stock futures contract on company X. you then take it one step further by buying put options on your futures position. For the premium paid, a long put gives you the right to sell the underlying instrument (future) at the puts strike price, should you choose to exercise it.
Three months later, you learn that you were correct; company X’s share prices have gone up and are now trading at $54 per share. You can now sell your single stock futures contract, which has increased in value along with the underlying security, for a profit. The put you purchased will simply expire unexercised at no harm to your position.
But what if you were wrong? What if the whoopie pies that company X produces have recently been discovered contaminated by salmonella and the result of the news on stock prices is devastating? Well, here is where the put would come into play.
Since the value of the futures contract is correlated with the underlying security, it has also plummeted in price and is now virtually worthless. However, by exercising your put option, you may sell your worthless futures contract at the strike price previously establish when the stock was trading healthfully. Even though company X’s stock price crashed and burned, taking your single stock futures position with it, you can sell it for a loss of only the premium you paid for it along with commissions.
Below is a chart showing a protective long put for visualization of potential outcomes. The red line is the put, and the blue is the spot market, but we will assume it’s the futures position for purposes of the example described above (since spot and futures move together). As you can see, should the stock position continue on an upward trend, you will profit with your long futures position. However, should it take a bearish turn and drop past your purchased put strike price (red) you will have the right to exercise and sell your futures at the strike, which will be more than it is worth.
So why don’t more people establish synthetic long call positions? Is it too much effort? Or do they just not know they exist?
One possibility could tepid congestion. Suppose the cash market stock drops a just few points; enough to sink below your futures purchase price, but not to the point of permeating your puts strike. Then, should congestion ensue until both derivatives reach expiration, you’re stuck with a loss. Granted it would still be limited to 1) the scope of the futures minus the strike of the put and 2) the put premium plus commission, but still, a loss nonetheless.
If you’re bullish, a synthetic long call could possibly serve as a well-protected strategy. Rather than buying the stock outright and risking a hefty loss should the market move against you, for the price of a few fees, you could purchase a put, combine it with a long futures, and limit your losses. Knowledge is power – a well-educated investor has a far better chance of success than an overzealous better.
Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.