Equity markets plunged to start the week based on increased FOMC pressure to raise rates to combat inflation. As markets tumble from recent highs seen last week, the at-the-money monthly $VIX option contract for September shows significantly more premium on the call side compared to the put side, indicating a potential bullish skew favoring an increase in volatility. One way to combat uncertainty in the market is to implement a hedge position in your equity portfolio. Today, I would like to discuss three different methods that can be utilized to hedge a large cap stock portfolio and provide context to the information necessary to place a proper hedge.
For the purposes of this discussion, let’s assume we are looking to hedge a $500,000 portfolio of large cap stocks using Index products that track the S&P 500. The E Mini S&P 500 or ES futures contract, SPY ETF, and $SPX options are three common products used to hedge a portfolio of large cap stocks.
We will also discuss the importance of beta weighting your portfolio. Beta is a measurement of volatility of an individual stock in comparison to the market. The level of the beta indicates the degree of correlation between a security and a market benchmark, in this example the S&P 500. A beta greater than 1 means the stock is more volatile than the overall market, while a beta less than 1 indicates that the security is more stable than the market. To find your portfolio’s beta you will need to multiply the percentage of the stock in your portfolio by its Beta, then add up the results of each position.
Another concept you will need to understand when hedging a portfolio is Delta. Delta measures how much an option's price is expected to change per $1 change in the price of the underlying security or index. For example, a Delta of 0.40 means that the option's price will theoretically move $0.40 for every $1 move in the price of the underlying stock or index.
In order to hedge a portfolio using the E Mini S&P 500 futures contract a client will need to first have a margin account that has been approved to trade futures. For the purposes of this discussion, we will assume a $500,000 portfolio of large cap stocks, which has a beta of 1. At the time this article was written, the E Mini S&P 500 September 2022 contract (ESU22) was trading at 4175.00 which computed to a notional value of $208,750 (4175.00x$50). In order to calculate the number of contracts needed to place the hedge we will divide the total portfolio value by the notional value of one ESU22 contract.