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Hedging Your Index ETFs with the New CME Micro Emini Futures

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For most equity investors, a secular bear market is something to fear. It can represent massive unrealized losses, a significant reduction of paper wealth, and a gradual vanishing of value that took months to build.

Aside from the battering that your portfolio undergoes, the truth is that the fear of losses--never knowing how deep it may go, or how long it may continue--is often worse than the event itself. How so? Just take a look at the average performance of the S&P 500 since the 1940s:

  • Average bear market decline is a little over -30%, lasting (on average) a year and four months.

  • Average bull market rise is nearly 150%, lasting on average four years and nine months!

This means that if you are well diversified, and dollar cost averaging during each bear, you would have come out well ahead after each bull/bear market cycle. Hence, the fear has historically been worse than the reality.

For some equity investors, a secular bear market is an opportunity to exploit. If you believe that a bear market is a natural part of the business cycle, and if you believe that the U.S. economy will remain one of the strongest economies across the globe, then a bear market represents an opportunity to cultivate financial growth.

You can do this one one of three ways: the first way is to continue dollar cost averaging; the second, is to hedge your portfolio by seeking to generate gains on the downside (i.e. going short the market); and the third way is to hedge while converting those downside gains into more dollar cost averaging.

Well talk about the second, hedging your portfolio, as it is something that many investors can easily misunderstand.

Hedging a Bear Market

Lets address the big caveat: you can easily mistake a correction for a bear, or a wall of worry for a wall of ruins. When you hedge, you risk loss if you are wrong. Hence, you should probably learn how to approach a hedge strategically, to know when to apply it, and tactically, to know how to exit it when youre wrong, before you attempt hedging your portfolio.

Obviously, you can go short your index ETF while you are holding it long. Some investors may also choose to use options via a put, which can be reasonably complex for those who dont understand how options work.

But lets talk about a direct hedge. Most investors wouldnt have been able to use standard emini futures contracts to hedge their index fund exposure either because they dont own enough shares to justify even one futures contract or their exposure wont match multiple contracts (say, their ETF exposure is equivalent to, say, two and a half contracts, or some uneven equivalence).

Using the New CME Micro Emini Contracts to Hedge Index ETF Exposure

The CMEs new micro products are being offered for four indices: S&P 500, Dow Jones Industrial Average, Nasdaq 100, and Russell 2000.

Each contract is a 10th of the regular emini contracts with the contract sizes as follows:

  • S&P 500 = $5 x index value

  • Dow Jones = $0.50 x index value

  • Nasdaq 100 = $2 x index value

  • Russell 2000 = $5 x index value

The dollar per tick value is $1.25 per contract for the S&P 500 and $0.50 per contract for the other three indices.

The opportunity here is that you can directly hedge your index ETF exposure by matching the index with the micro futures and matching the dollar per tick value of the micro contracts to that of your ETFs. Because of the fractional exposure that the contracts offer, you may be able to better fine tune your hedge to your equity exposure.

As with every investment opportunity, there are, of course, caveats. You will have to post margin for your futures positions. You will have to learn about contract expirations and rolling over a futures contract. You also need to learn about the risks of hedging and how to execute and effective hedge and how to exit it should your assessment be wrong.

But if you are willing to learn how to hedge your portfolio, for protection or potential profit, the new micro emini contracts might be something to consider.

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The risk of loss in the trading of stocks, options, futures, forex, foreign equities, and bonds can be substantial and is not suitable for all investors. Trading on margin or the use of leverage is not suitable for all investors and losses exceeding your initial deposit is possible. Supporting documentation is available upon request. Trading futures, options on futures, and FX involves substantial risk of loss and is not suitable for all investors. Carefully consider whether trading is suitable for you in light of your circumstances, knowledge, and financial resources and only risk capital should be used. Opinions, market data, and recommendations are subject to change at any time. The lower the margin used the higher the leverage and therefore increases your risk. Past performance is not necessarily indicative of future results.

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About the author

Karl Montevirgen is an independent content writer and financial content entrepreneur. Having been involved in the commodities and FX markets for the last 9 years, Karl writes for several companies and publications in the finance, blockchain, cannabis, and content space. 

You can view his extended profile, list of publications, and theoretical content work on his LinkedIn page. 

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