Hedging is a risk reduction strategy whereby investors and traders take offsetting positions in an instrument to reduce their risk profile. The practice usually involves taking both a long and a short position in an instrument and so, usually, necessitates using financial derivatives with which it is possible to short sell.

Hedging strategies are also employed by professional fund managers to control the risk exposure of large managed funds. In this context, hedging is a more complex process as it involves a whole portfolio of different investments - each with its own unique risk/return profile.

Futures contracts can be an extremely useful heding tool.

The principle of hedging is simple: as the value of your assets fall, the value of the hedge increases, therefore offsetting these losses.

In a perfect hedge the profit on the hedge will exactly offset the loss on your underlying position. However, most hedges are unlikely to be perfect, as there will be slight differences between the price movements of the derivatives you have chosen and your cash market holdings, or the number of derivatives contracts you buy doesn’t exactly match the exposure you have.

Example

You hold a diversified portfolio of shares, which broadly match movements in the Dow Jones Industrial Average (DJIA), and you anticipate a temporary fall in market value. You are unwilling to liquidate your portfolio as it is part of your long term strategy.

To protect the portfolio you could use index futures, which are available on all the major world markets.

The exposure an index future gives is found by multiplying the value of the index future (i.e. what it is quoted at) by the value per point of the futures contract. The Dow Jones Industrial Average futures trading on the CBOT are worth $10 per point, so if the futures were quoted at 10,600 then one contract gives an exposure of 10,600 x $10 = $106,000.

Suppose your US portfolio is worth roughly $5m. In this case you would need $5,000,000 / $106,000 = 47 futures contracts to hedge your holdings. As you are long the market, you sell futures contracts in order to profit from any fall in price.

Let's assume that when the hedge is set up in January, the Dow is at 10580. By March, when the March futures contracts you have bought stop trading, the index is at 10400, a fall of 1.7%.

With the index now at 10400, profits and losses are:

In this case, the hedge has actually over compensated for the loss in value of your equity portfolio.

Of course, if your expectations were wrong, and the index went up instead of down, then a profit would have been made on the portfolio, which would have been reduced by the loss on the hedge.

Let's assume the market had gone up by 1.7%. What would the net position have been:

In this case upside gains have been sacrificed by the presence of a hedge.

In reality, as we have already seen, the fact that you can close out whatever position you have adopted before expiry means you are unlikely to hold the hedge if your original view looks like it is going to be incorrect.