Explain how to use stock index futures to lock in the benefit of a stock selection

[akrushn2]

Hi guys,

Why would I short future if my stocks outperform to lock in the profit? I don't quite understand this concept. Doesnt short futures act as a hedge to mitigate against stock price decreases? how does it lock in the profits of stock prices going up? I don't quite get this.

I tried searching for this on the forum but couldn't find it. Any help would be appreciated.

 

[David Harper CFA FRM]

Hi @akrushn2

If you held a well-diversified portfolio and hedged (almost) perfectly by shorting futures contracts on an index (eg, S&P 500) then it could lock in the "net profits." As mentioned in the other thread, a hedge is always two positions (underlying exposure + hedge), so in extremis, if the market drops (like in the last two days), the gain in the short futures contract offsets (or mitigates) the loss on the portfolio. So the idea is that you may wan to lock in the "net" profits where net is both positions. However, see Hull quote below, it's unclear why you would hedge perfectly rather than just sell, right? So more realistically, you would hedge the beta to immunize from market drop while retaining your hope of outperforming with the individual stocks; i.e., neutralize beta but keep the alpha. Here is a video of mine on the equity beta hedge https://forum.bionicturtle.com/thre...cts-to-neutralize-or-alter-equity-beta.22418/

... and here is Hull on the reason (emphasis mine):

Reasons for Hedging an Equity Portfolio: Table 3.4 shows that the hedging procedure results in a value for the hedger’s position at the end of the 3-month period being about 1% higher than at the beginning of the 3-month period. There is no surprise here. The risk-free rate is 4% per annum, or 1% per 3 months. The hedge results in the investor’s position growing at the risk-free rate.

It is natural to ask why the hedger should go to the trouble of using futures contracts. To earn the risk-free interest rate, the hedger can simply sell the portfolio and invest the proceeds in a risk-free security.

One answer to this question is that hedging can be justified if the hedger feels that the stocks in the portfolio have been chosen well. In these circumstances, the hedger might be very uncertain about the performance of the market as a whole, but confident that the stocks in the portfolio will outperform the market (after appropriate adjustments have been made for the beta of the portfolio). A hedge using index futures removes the risk arising from market moves and leaves the hedger exposed only to the performance of the portfolio relative to the market. This will be discussed further shortly. Another reason for hedging may be that the hedger is planning to hold a portfolio for a long period of time and requires short-term protection in an uncertain market situation. The alternative strategy of selling the portfolio and buying it back later might involve unacceptably high transaction costs." --Hull, John C.. Options, Futures, and Other Derivatives (Page 66). Pearson Education. Kindle Edition.