Hedging Equities or FX with Futures

Beta hedges that can still lose on basis.

Intermediate 5 min read Course 29 of 60

Course 29 of 60 in the futures hub. This one is about using index or currency futures to protect a position you already hold, and the risks a hedge brings with it.

What a hedge actually does

A hedge trades one risk for a smaller one. Selling index futures against a stock portfolio cuts your exposure to a market drop, but it brings in new risks: the futures and your stocks won't move exactly together, the contract expires, and the ratio may be off. A hedge that's done properly still shows losses on some days.

The way people get hurt is hedging and then trading the hedge, taking it off on a green morning and putting it back after a red one. At that point it's a second strategy with its own P&L. Currency exposures work the same way, and the spot side of that is in the forex course.

1. Know what you are hedging

Start with a sentence: what am I protecting, against what, and for how long? "My $250,000 of large U.S. stocks against a broad market drop over the next month" is a hedge. "I'm nervous" is not a plan. The answer tells you which contract to use and when the hedge should come off.

Match the contract to the exposure. A portfolio of tech names tracks the Nasdaq-100 better than the S&P 500; a euro receivable matches euro futures. Get this wrong and you're hedging something you don't own. Keep the P&L of both sides on one sheet, which the P&L calculator makes easier.

2. The ratio math

Size the hedge in dollars, never in contracts that "feel right." Work out the dollar exposure, adjust it for how much your holdings move relative to the index, then divide by the dollar value of one futures contract. At an illustrative index level of 5,000:

Book $250,000, beta 1.0 ÷ (ES at 5,000 × $50 = $250,000 per contract) = 1 contract. Same book with beta 1.2: $300,000 ÷ $250,000 = 1.2, so one contract leaves 0.2 unhedged.

Index levels move, so redo the math whenever the market has moved a lot or you've changed the portfolio. Contracts only come in whole numbers, so you'll almost always be a bit over or under. Micro contracts help close the gap, since each is a tenth of the E-mini. Write down the leftover and decide if you can live with it. The stop and target calculator helps if you want a stop on the residual.

Hedge ratio is dollars of beta, not 'one ES per account' contracts ≈ (dollar beta to hedge) ÷ (future $ per 1% ) Equity book $200k, beta 1 not automatically 1 ES Look up $ / point then convert Overhedge is a new short Underhedge is leftover long

3. Basis risk

Basis is the difference between the futures price and the thing you're hedging. Over the life of a hedge, that difference changes. If your stocks fall 5% and the index future falls 4%, the hedge covers most of the loss but not all of it. If you picked the wrong index, the gap can be much bigger.

There's also the roll. Hedging for longer than one contract's life means rolling into the next month, which costs fees and spread and may happen at a poor price. Note the expiry of the contract you use on day one. The free calculators help you track what the roll costs.

A hedge can still lose when cash and the future disagree What you wanted Offset the betaSleepStatement looks flat What can happen Basis blows outWrong contract monthWrong index (NQ vs ES)

4. Overhedging

Holding more futures than your exposure means you're no longer hedged; you're short the market with the extra. If the market rallies, the hedge loses more than the portfolio gains. People slide into this by adding contracts after a scary day without redoing the math.

The reverse, underhedging, leaves part of the portfolio exposed. Both are fine as long as they're deliberate. Write the ratio down, and check it against the actual dollar value of the holdings each week. If the holdings are individual stocks, the stock glossary explains beta and the other terms used here.

5. When not to hedge

Sometimes the simpler answer is to sell some of what you own. If you'd be relieved to have less exposure for the next year, cutting the position costs less attention than running a futures hedge, rolling it, and watching the basis. Hedges suit exposures you have to keep, like a long-term holding or a known currency payment.

Ask whether you can name the leftover risk after the hedge. If you can't, don't hedge yet. Spreads between related futures are a cousin of this idea and come up in the spread strategies lesson.

Is the 'hedge' actually a second opinion? Can you name the residual? Hedge is a job ratio on paper Do not hedge cut the cash instead

6. Common hedging mistakes

Using the wrong index for the portfolio. Sizing by contract count instead of dollars. Forgetting the expiry. Taking the hedge off the first day the market goes up, which turns it into a market-timing trade.

And one that surprises people: the hedge loses money whenever the portfolio gains. That's what it's supposed to do. The next lesson, on seasonality, moves back to trading ideas.

A worked currency hedge

Say a U.S. company expects to receive €250,000 in three months. A weaker euro means those euros buy fewer dollars. Two short euro futures contracts at €125,000 each cover the amount, and you'd pick the contract month that expires nearest the payment date.

If the euro drops 2 cents, the receivable loses about $5,000 in dollar terms and the two short futures gain about $5,000. A 2-cent rise does the reverse. Either way the dollar amount is roughly locked, apart from basis and timing. The company gave up the chance of a windfall to remove the chance of a shortfall.

Before you place a hedge

  • Write what you're protecting, against what, and until when.
  • Size in dollars, adjusted for beta, divided by one contract's value.
  • Expect basis and roll costs; a hedge is never perfect.
  • Leave the hedge alone unless the exposure itself changes.

If cutting the position would let you sleep just as well, cut it and skip the hedge. Educational only. Not a recommendation to buy, sell, or hold any contract or pair.