The primary function of futures or derivative contracts is not solely for speculation only, as is popularly perceived to be, but rather it serves to enable financial professionals and institutions to hedge their current positions in equities, commodities etc, in order to limit losses or act as an insurance policy against any unforeseen “events”. There are many ways to create a hedge other than using futures. The hedge can also be created using options, be it stock options or futures options. It must be noted that hedging normally carries a cost to it and unless one is very skillful, it is very difficult to create a perfect hedge that is free. The following scenario best illustrates an example of hedging using stock index futures:

Hedging Using Derivatives As A Form Of Insurance Policy

Lets say fund manager George just bought 10 million shares of Intel (INTC) as his firm’s technical and fundamental analysis indicates a bottoming in the stock price. What George didn’t figure in happening is receiving “whisper numbers” on another company in Intel’s sector, lets say Advanced Micro Devices (AMD), that their earning’s guidance for next quarter looks bad. George knows that when the word gets out into the open market, what will normally happen is a knee jerk reaction to the news and all stocks in that sector will be hammered hard. Realizing this, George wants to protect the value of the Intel shares he just bought so he goes to the S&P500 index futures market and tries to discretely “short sell” a number of contracts amounting to a value close to his Intel shares in the hopes of creating a 1:1 hedge. (The S&P500 index futures contract is a derivative of the S&P500 Cash Stock Index. It has an electronically traded E-mini version which is one fifth the size of the main pit-traded contract. Other popular futures contracts used for hedging & speculating include the Nasdaq & Dow Jones Index Futures.)

How Does the Hedge Work?

What George has done is that he has created a hedge in order to limit the loss on his Intel position. He is expecting the S&P 500 index futures to also drop on the bad earnings news and his gain on his “short” futures position should mitigate his loss on his “long” Intel position. The premise is that the overall market will react badly to this news since Intel is a blue chip S&P 500 component and it is in a very important semiconductor sector which should affect the performance of the entire economy.

Low Liquidity & Spooking The Markets

Why did George short sell the S&P 500 index futures and not just sell his 10 million Intel shares? The problem is liquidity. If George goes into the open market and tries to sell-off his huge position, he will definitely spook the market. When the bad news hits the wires, the liquidity on Intel at a price close to where George bought will be practically zero as the market will adjust the price to a level where the buyers are comfortable in buying! For George to let go of his huge Intel position would have meant negotiating a big block trade with a large institution at a significantly marked down price. In the case of futures, the liquidity is normally better which may enable him to have sufficient time to put on a hedge.