Hedging a Stock Portfolio with Index Futures
You hold a basket of stocks you don't want to sell, but you fear a market drop? Sell index futures according to the portfolio's beta, and keep only your stock-picking skill.
Risk warning: forex, CFDs, options, futures and crypto assets usually involve leverage or high volatility, and you can lose more than you put in. This lesson only teaches the concepts; all numbers are for illustration and are not investment advice.
Every lesson has an interactive simulation you can drag and play, plus a quick quiz. Sign up free to use them and save your progress automatically. Here is the text version of this lesson.
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Text version · Hedging Strategies, lesson 3: “Hedging a Stock Portfolio with Index Futures”
You hold a basket of stocks you don't want to sell, but you fear a market drop? Sell index futures according to the portfolio's beta, and keep only your stock-picking skill.
β: how much the portfolio moves with the market
A portfolio with a beta (β) of 1.2 rises 12% on average when the market rises 10%, and falls are magnified the same way. So when hedging, work out the real market exposure as "β × market value," not just the market value.
Hedge out the market, keep the stock picking
Contracts to sell = β × portfolio value ÷ (futures level × contract multiplier). Once the market part is offset by the futures, what's left is the α from stock picking: the core of a market neutral strategy.
No need to go to zero: aim for a target β
Bearish on the market but don't want to get out entirely? Sell only some futures to cut β from 1.2 to 0.5: contracts = (current β − target β) × market value ÷ value per contract. As holdings change, β drifts too, so the hedge needs regular rebalancing.
Key takeaways
- Number of contracts = β × portfolio value ÷ (futures level × contract multiplier).
- After a beta hedge, the portfolio no longer reacts to market moves; only the excess return from stock picking, alpha (α), remains.
- High-beta portfolios need more contracts; hedging 1:1 by market value leaves you under-hedged.
- You can also just bring beta down to a target: contracts = (current β − target β) × portfolio value ÷ value per contract.
Try it yourself
You can do these exercises in this lesson's interactive simulation:
- Click "Example: β 1.2 · market −10%": how many contracts do you need to sell? How far is the total P&L from the stock-picking α? Where does the difference come from?
- Switch to "1:1 by market value": selling only 8 contracts, how much does the portfolio still lose when the market falls 10%? What does "Residual β" show?
- Go back to "Hedge by β" and drag the market from −20% to +20%: why is the green total line almost flat?
- Drag α to −3% (bad stock picking): can the hedge still protect you?
Quiz and explanations
- 1. A portfolio is worth $2,000,000 with β = 1.2. Index futures are at 5,000 points, $50 per point. Roughly how many contracts should you sell?
- Answer: 10.1.2 × $2,000,000 ÷ (5,000 × $50) = 9.6, about 10 contracts.
- 2. After a full beta hedge, the market falls 10%. What mainly remains in the portfolio?
- Answer: The excess return α from stock picking.The market part is offset by the futures; what's left is performance relative to the market.
- 3. A $2,000,000 portfolio has β = 1.2, and you only want to bring β down to 0.5. Index futures are 5,000 points × $50. Roughly how many contracts do you sell?
- Answer: 6.(1.2 − 0.5) × $2,000,000 ÷ $250,000 = 5.6, about 6 contracts. A hedge doesn't have to go to zero; you can adjust to a target beta.
Terms in this lesson
- alpha (α) (Alpha): Excess return after removing the market's influence, reflecting stock-picking skill.
- beta (β) (Beta): How sensitive a portfolio is to the market; β = 1.2 means it rises 1.2% on average when the market rises 1%.
- market neutral (Market Neutral): A portfolio that isn't sensitive to market moves, earning mainly from alpha.