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Smart Investor - Using options on index futures as a risk management tool
Options 10 minutes to read
Koen Hoorelbeke
Investment and Options Strategist
Options are complex, high-risk products and require knowledge, investment experience and, in many applications, high risk acceptance. We recommend that before you invest in options, you inform yourself well about the operation and risks.
Using options on index futures as a risk management tool
Introduction
Investing in financial markets can be rewarding, but it comes with risks, especially during periods of heightened uncertainty. While many investors are familiar with products like stocks, bonds, or even commodities, fewer understand the tools available for protecting their portfolios against downturns. Among these, options on futures—specifically on broad market indices like the S&P 500—offer a flexible and effective way to manage risk.
Futures contracts might bring to mind images of traders buying oil or wheat. However, futures aren’t limited to commodities. They’re also widely used for indices like the S&P 500, which represent the performance of the broader stock market. For investors with diversified portfolios, these index-based futures and their options are excellent tools for hedging against market volatility.
Hedging with such products allows you to offset potential losses in your portfolio while staying invested to benefit from potential gains. Let’s dive deeper into why options on futures, and particularly protective puts, are among the best strategies for risk management.
Important note: the strategies and examples provided in this article are purely for educational purposes. They are intended to assist in shaping your thought process and should not be replicated or implemented without careful consideration. Every investor or trader must conduct their own due diligence and take into account their unique financial situation, risk tolerance, and investment objectives before making any decisions. Remember, investing in the stock market carries risk, and it's crucial to make informed decisions.
Understanding options and futures
Options and futures are financial derivatives—contracts whose value is derived from an underlying asset, such as a stock index, commodity, or interest rate. While they share some similarities, there are key differences that make each uniquely suited to particular strategies.
Futures: A futures contract obligates the buyer and seller to transact the underlying asset at a predetermined price on a specified date. Each contract has a set size, and for S&P 500 E-mini futures (ES), the multiplier is $50 per point. For example, at an index level of 6,000, one ES contract represents $300,000 of exposure. Futures are traded on margin, requiring only a fraction of the contract's value upfront, but gains and losses are settled daily (mark-to-market).
Options on futures: An option provides the right, but not the obligation, to buy or sell the underlying futures contract at a specific price (strike price) before expiration. This flexibility comes with a cost—called the premium. Like futures, each ES option contract has a $50 multiplier. However, the optionality of these contracts makes them particularly valuable for risk management.
Another key advantage is that options on futures can be traded 24/5. Unlike options on stock indices, which are tied to stock market hours, you can trade these contracts overnight, reacting immediately to global events. This ensures you’re not left vulnerable during off-hours when the underlying market moves significantly.
Why hedge using an index?
For most investors, portfolios are broadly diversified across multiple sectors or asset classes but often remain correlated to the overall performance of the stock market. A sharp downturn in the S&P 500, for example, is likely to result in significant portfolio losses—even if the portfolio isn’t directly invested in the same stocks as the index.
Hedging with a product tied to a broad index, like the S&P 500, makes sense because it offers:
- Broad protection: Index products capture the overall market's movement, effectively hedging a portfolio that is moderately correlated to the market.
- Simplicity: It’s easier and more cost-effective to hedge with a single index option than to attempt to hedge each individual stock.
- Liquidity: Products like S&P 500 futures and options are highly liquid, ensuring tight spreads and efficient execution.
This makes index-based hedging a practical and scalable solution for managing risk in diversified portfolios.
Why hedge with protective puts?
Protective puts are one of the simplest and most effective ways to hedge a portfolio. By purchasing a put option, you gain the right to sell the underlying futures contract at a predetermined price, providing a safety net in the event of a market drop.
Example:
- You own a portfolio worth $100,000, which closely tracks the S&P 500.
- The index is at 6,000, and you buy a 5,700 put option for $23 per point, costing $1,150 (since the multiplier is $50).
- If the S&P falls to 5,600 before expiration:
- The put’s intrinsic value is 100 points × $50 = $5,000.
- After subtracting the premium, your net gain is $5,000 - $1,150 = $3,850.
If a sharp market decline occurs before expiration, implied volatility tends to surge. This increase in volatility can significantly boost the price of your options, even beyond their intrinsic value.
Beyond the basics: laddering for extended protection
Once you’re familiar with protective puts, you may want to consider strategies to optimize costs and extend your hedge over longer periods. One approach is laddering your hedges—a method similar to dollar-cost averaging but applied to insurance.
Instead of buying all your hedges at once, spread them out over time at different strike prices and expiries.
Benefits of laddering:
- Lower overall cost: By purchasing hedges gradually, you can take advantage of premium reductions due to changes in volatility or market conditions.
- Extended coverage: Staggering expiries ensures your portfolio remains protected over longer time frames.
Example:
- Buy a 5,700 put expiring in three months.
- Add a 5,600 put expiring in six months.
This layered approach balances cost and protection, offering flexibility to adjust as market conditions evolve.
Conclusion: A straightforward yet effective strategy
Hedging your portfolio doesn’t need to be overly complex. Protective puts on futures offer a simple and effective way to mitigate the risks of market downturns while keeping your portfolio positioned for upside. By utilizing index-based products like S&P 500 futures, you gain broad, scalable protection that aligns with most diversified portfolios.
For those looking to take their risk management a step further, strategies like laddering can optimize costs and extend coverage, while more advanced approaches—such as spreads or collars—offer tailored solutions for specific situations.
Ultimately, in the ever-changing world of financial markets, having a clear hedging plan ensures you’re prepared for the unexpected. With protective puts, you gain peace of mind knowing that no matter how turbulent the market becomes, your portfolio is ready to weather the storm and seize the next opportunity.
| Check out these guides and case studies: |
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| In-depth guide to using long-term options for strategic portfolio management Our specialized resource designed to learn you strategically manage profits and reduce reliance on single (or few) positions within your portfolio using long-term options. This guide is crafted to assist you in understanding and applying long-term options to diversify investments and secure gains while maintaining market exposure. |
| Case study: using covered calls to enhance portfolio performance This case study delves into the covered call strategy, where an investor holds a stock and sells call options to generate premium income. The approach offers a balanced method for generating income and managing risk, with protection against minor declines and capped potential gains. |
| Case study: using protective puts to manage risk This analysis examines the protective put strategy, where an investor owns a stock and buys put options to safeguard against significant declines. Despite the cost of the premium, this approach offers peace of mind and financial protection, making it ideal for risk-averse investors. |
| Case study: using cash-secured puts to acquire stocks at a discount and generate income This review investigates the cash-secured put strategy, where an investor sells put options while holding enough cash to buy the stock if exercised. This method balances income generation with the potential to acquire stocks at a lower cost, appealing to cautious investors. |
| Case study: using collars to balance risk and reward This study focuses on the collar strategy, where an investor owns a stock, buys protective puts, and sells call options to balance risk and reward. This cost-neutral approach, achieved by offsetting the cost of puts with the premiums from calls, provides a safety net and additional income, making it suitable for cautious investors. |
Options are complex, high-risk products and require knowledge, investment experience and, in many applications, high risk acceptance. We recommend that before you invest in options, you inform yourself well about the operation and risks. In Saxo Bank's Terms of Use you will find more information on this in the Important Information Options, Futures, Margin and Deficit Procedure. You can also consult the Essential Information Document of the option you want to invest in on Saxo Bank's website.