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Strategies

Strategies involving futures can broadly be described as either hedging strategies or speculative strategies.

In using futures to hedge, you may be looking to lock in the value of a portfolio of shares you hold. Alternatively, you can use futures to hedge an anticipated purchase of shares. In using futures to hedge, you are reducing the risk of your share portfolio.

Futures also are an ideal way of gaining leveraged exposure to moves in the sharemarket, enabling you to trade a view on the broad market in one transaction. This use of futures offers the possibility of large percentage returns on your trades – at the same time, you are exposed to the risk of significant losses.

Described below are two strategies that give you exposure to the sharemarket through futures.

  • Sell futures to hedge a share portfolio
  • Buy futures for leveraged exposure

Sell futures to hedge a share portfolio

Assume you hold a share portfolio that trades in line with the S&P/ASX50 index. By selling index futures, you can lock in the value of the portfolio until maturity of the futures contract.

If the index falls after you sell the futures contract, the value of your portfolio will also fall, and so too will the price of the index futures contract. The loss on your shares will be offset by a profit on the futures transaction when you close out your futures position. 

If on the other hand the index rises, both the futures price and the value of your share portfolio will increase. The increase in the value of your shares will be offset by a loss on the futures transaction.

This illustrates an important difference between the use of put options and the use of futures to protect shareholdings. In selling futures you do not have the possibility of benefiting from a rise in the value of your shares, as any increase in their value will be offset by a loss on the futures contract; in contrast, buying a put option still allows you to benefit from a rise in the value of your portfolio. However, in selling futures you do not incur the expense of the premium you must pay when you buy a put option.

Example: assume you own a portfolio of shares that trades approximately in line with the S&P/ASX 200 index. On July 1 your portfolio is worth $120,000. You are concerned that over the next two to three months the sharemarket will decline, and want to lock in the value of your portfolio.

The S&P/ASX 200 index stands at 5000 points, and ASX SPI 200 futures are trading at 5020 points. You sell an ASX SPI 200 futures contracts at 5020 points.

At the start of September, the S&P/ASX 200 Index has fallen to 4750 points, and your share portfolio is now worth $112,000. ASX SPI 200 futures are trading at 4,760points. You decide to close out your futures position by buying back the ASX SPI 200 futures contracts.

The table shows the results of your hedging strategy:

Sharemarket Futures
1 July 1 July
S&P/ASX 200 - 5000 points

Share portfolio - $125,500
Sell an ASX SPI futures @ 5020 points
= 1 x 5020 x $25
= $125,500 (Initial margin payment = $6,000)
1 September 1 September
S&P/ASX 200 - 4,750 points
Share portfolio - $112,000
Unrealised loss = $8,000

Buy an ASX SPI futures @4,760 points 

= 1 x 4,760 x $25
= $119,000
Profit on futures = $6,500

You can see that the loss in value of your share portfolio has been offset by the profit you made on the futures transaction.

You have in fact made more on the futures transaction than you lost on your share portfolio. This is due to three factors:

  • you were slightly over-hedged – you sold futures contracts with a total face value of $125,000, although your share portfolio was worth only $120,000
  • your share portfolio may not have moved exactly in line with the S&P/ASX 200 index
  • the futures and physical prices have converged. When you opened the futures position futures were trading at a 20-point premium to the index; when you closed the futures position the premium was just 10 points. Convergence is a normal characteristic of futures pricing. See how futures are valued for more details.

The initial margin assumed in this example is $6,000 per contract. Initial margins are determined by ACH according to the volatility of the underlying index and are reviewed regularly.

While your futures position remained open, you would have been subject to variation margins. See futures margins for more information on the way futures positions are margined.

The hedging strategy has protected the value of your share portfolio. Had the S&P/ASX 200 Index risen over this period, your share portfolio would have increased in value, however you would have suffered a loss on closing out your futures position. The overall result would have been similar – a profit in one instrument offsetting a loss in the other.

Buy futures for leveraged exposure

ASX SPI futures provide you with leveraged exposure to movements in the underlying index. Your initial outlay when you trade a futures contract is a small percentage of the value of the contract. Therefore, if the market moves in your favour, the percentage returns you make from trading the futures contract will be significantly higher than the percentage movement in the underlying index.

Example: Assume it is early November, and the S&P/ASX200 index is at 4,750. You believe the market will rise over the next few weeks, and decide to buy an ASX SPI 200 future. The December contract is trading at 4,875 points.

Two weeks later, the index has risen to 4,850 points, and the December futures contract is trading at 4,875 points, You decide to close out your position by selling the December futures contract.

Date 1 November
Opening trade Buy 1 December ASX SPI 200 future
Index level 4,750
Futures price/value 4,775 / $119,375
Initial margin paid $6,000

 

Date 15 November
Closing trade Sell 1 December ASX SPI 200 future
Index level 4,850
Futures price/value 4,850 / $121,750
Initial margin refunded $6,000
Profit $2,375

Note: the initial margin assumed in this example is $6,000.

Because your outlay at the time of the opening transaction is limited to the initial margin, the percentage return made on your investment is greater than the movement in the underlying index.

It is important to understand that the leveraged exposure provided by futures can also lead to substantial losses. If in the example the market had fallen, the losses you would have suffered on the trade would have been greater in percentage terms than the decline in the index.

You should discuss with your investment adviser whether the risks of leveraged exposure are appropriate to your circumstances.