Using single stock futures to reduce your portfolio’s risk
Despite being a risky financial instrument, single stock futures
can help you to hedge your existing shareholdings. In other words, you can use single stock futures to protect your existing portfolio.
So how does hedging actually work?
Let’s say you have a substantial portfolio of large-cap shares. You think that a big correction is about to hit the stock market and you’re worried about your portfolio.
What are your options?
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There are a number of things you could do…
Take no action
You could just sit it out. This means watching the value of your portfolio decline with the market. But if you’re investing for the long-term, you’re prepared to hold on and wait for an inevitable market recovery.
Sell your shares
You could sell all your shares. This means if the market does take a big dip, your portfolio won’t suffer. You could put the money into bonds or just hold it in cash. Then you’d buy back once the worst was over. The larger your portfolio, the more commissions and fees you’ll pay your stock broker.
Or you could hedge your portfolio with single stock futures
Instead of selling your shares, you could use single stock futures to hedge your portfolio instead. As your share holdings are mostly in the Top 40 Index on the JSE, you could short sell
an ALSI40 futures contract instead.
This type of index future follows the underlying index, just like single stock futures following the underlying shares they derive their value from.
If the market does fall, you’ll gain from an increase in the value of your futures trade. This will help to offset losses in your portfolio.
But if you get it wrong, you’ll lose money on the futures contract, but your share portfolio will gain.
The purpose of hedging isn’t to make money. It’s a way of insuring your portfolio against losses.
If you followed this route, you’d close out your futures trade when the market started to rise again.
So there you have it. How to use single stock futures to hedge your portfolio.
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