Equities · E9 · 8 min
Hedging an equity portfolio
Pick a way to protect a share portfolio from a fall, and work out what it costs and what it still leaves exposed.
In the news: “Investors rush for downside protection”: what they buy, what it costs, and what each choice still leaves exposed.
The essentials
- Hedging with futures
- A hedge is a second trade that gains when the portfolio loses. Selling index futures is the quickest, with no premium, but gives up the upside: £20m that tracks the FTSE 100 needs about 222 contracts at 9,000 (£10 a point).
- Beta and basis risk
- A portfolio with a of 1.5 moves 1.5% for each 1% in the index, so it needs 1.5 times as many futures. Stocks that fall further than the index are left uncovered: that is .
- Buying puts
- A pays below its strike and keeps all the upside, for a premium paid up front: a 95% put costing 2% on £20m costs £400,000. Protection is dearest when is already high.
- Collars and put spreads
- A zero-cost buys a put and sells a call that pays for it: a floor and a cap, with no premium. A put spread sells a lower put to cut the cost and covers only falls between the strikes: 95/85 covers 5% to 15%.
- Matching the hedge to the fear
- Puts suit fear of a crash while keeping the upside; a put spread, a moderate fall at low cost; a collar, no premium in return for capped gains; futures, getting out of the market fast.
Futures to hedge a portfolio
Contracts = portfolio value × beta ÷ (futures price × £ per point)
- beta
- how much the portfolio moves for each 1% move in the index
- £ per point
- the contract’s size: £10 a point on the FTSE 100 future
How it works
1. Why hedge
A hedge is a second trade that gains when your portfolio loses, so the two together lose less. It protects against a fall without selling. A fund holding £20m of UK shares that move with the FTSE 100 might fear a fall over the next three months but want to keep the stocks, as selling and buying back costs money.
2. Selling futures
The quickest hedge is to sell worth the portfolio. With the FTSE 100 future at 9,000 and £10 a point, one contract covers £90,000, so £20m needs about 222. If the index falls 20%, the shares lose £4m and the futures gain about £4m. But if it rises, the futures lose what the shares gain: no upside.
3. Beta, and what futures miss
If your portfolio moves 1.5% for each 1% in the index, its is 1.5, so you need 1.5 times as many futures. Even then, if your stocks fall further than the index, the hedge doesn’t cover the difference. That leftover risk is .
4. A put: insurance with a premium
A on the index pays out if the index ends below a set level, its strike. Buy a put at 95% of today’s level and any fall beyond 5% is covered, while you keep all the upside. Like insurance, you pay a premium up front, whatever happens. On £20m, a 95% put costing 2% costs £400,000.
5. What protection costs
A put costs more the closer its strike is to today’s level, the longer it lasts, and the bigger the swings traders expect, called . So protection is dearest when fear is already high. Puts well below today’s level also cost more than you might expect, because investors pay up for crash protection: that is .
6. A collar: no premium, capped gains
To avoid paying the premium, sell a as well: you give away gains above its strike, and the money you receive pays for the put. Buying a 95% put and selling a 103% call at the same price is a zero-cost . You keep a floor at 95% and a cap at 103%.
7. A put spread: cheaper, but partial
Buy a 95% put and sell an 85% put. The one you sell pays back part of the cost, but it means you are covered only for falls between 5% and 15%. If the index falls 20%, the spread pays 10% of the portfolio, and the last 5% of the fall is yours again. This is a put spread.
8. Matching the hedge to the fear
Start with what the client fears and what they want to keep. A crash, keeping all the upside: buy puts. A moderate fall, as cheaply as possible: a put spread. No premium, accepting a cap on gains: a collar. Out of the market for a while, fast: sell futures.
Worked example
You run £20m that moves with the FTSE 100. Suppose three-month options cost: a 95% put 1.7% of the portfolio, an 85% put 0.4%, and a 103% call 1.7%. The index then falls 20%.
- Unhedged: £20m × 0.80 = £16.0m.
- 95% put: floored at £19.0m, less £0.34m premium = £18.66m.
- 95/85 put spread, costing 1.7% − 0.4% = 1.3%: £16.0m + 10% × £20m = £18.0m, less £0.26m = £17.74m.
- Zero-cost collar (buy the 95% put, sell the 103% call): £19.0m, but gains above 3% are given up.
Put £18.66m, put spread £17.74m, collar £19.0m with gains capped at 3%, unhedged £16.0m.
Check yourself
8 quick questions on the explanation above.
Practice
New numbers every set. Misses and guesses go into your review deck.
In the interview
Answer out loud in under a minute, then compare.
A client fears a 10% fall over three months. What would you suggest, and why?
Why might a put spread beat a put?
What’s the downside of hedging with futures?
Remember
Contracts = value × beta ÷ (futures price × £ per point)
Every hedge trades cost against protection: futures cost nothing but take the upside, puts keep it for a premium, and collars and spreads sit between.
Sources
Definitions and maths are standard textbook material; dated facts link to the sources above. Worked numbers are illustrative.