Simple Futures Hedging Example
Simple Futures Hedging Example
Welcome to the world of hedging! If you own an asset in the Spot market (meaning you own the actual asset, like holding 10 Bitcoin), you might worry about that asset's price dropping. Hedging is a risk management strategy used to offset potential losses in one investment by taking an opposite position in a related investment. A Futures contract allows you to do this easily.
This article will explain a simple hedging example using futures contracts to protect your existing spot holdings. This is a fundamental skill for managing risk, especially when considering advanced topics like Leveraged Futures Trading: Maximizing Profits Safely.
Understanding the Goal: Protecting Spot Holdings
Imagine you own 100 shares of Company XYZ, which you bought at $50 per share. You believe in the long-term value of Company XYZ, but you are nervous about a major economic announcement coming out next month that might cause a temporary price drop. You do not want to sell your 100 shares because you want to keep them for the long term.
This is where hedging comes in. You can use a Futures contract to create a temporary "insurance policy" against a price drop.
A futures contract is an agreement to buy or sell an asset at a predetermined price at a specified time in the future. If you are worried about the price going down, you need to take a *short* position in the futures market.
The Concept of Partial Hedging
Full hedging means perfectly offsetting the risk of your entire spot position. Partial hedging means only offsetting *some* of the risk, which is often more practical, especially for beginners.
Why partial hedge?
1. You only expect a small, temporary drop. 2. You still want to benefit from a small price increase. 3. You want to keep costs (like margin requirements for futures) lower.
Let's continue the Company XYZ example.
- **Spot Holding:** 100 shares of XYZ at $50 each (Total value: $5,000).
- **Market View:** Expecting a temporary drop over the next month, but long-term positive.
- **Futures Contract Size:** Assume one XYZ futures contract covers 10 shares.
If you wanted to *fully* hedge, you would need 10 futures contracts (100 shares / 10 shares per contract) sold short.
For a *partial hedge*, let’s decide to hedge 50% of the risk.
- **Hedge Size:** 50% of 100 shares = 50 shares.
- **Futures Contracts Needed:** 50 shares / 10 shares per contract = 5 short futures contracts.
By selling 5 XYZ futures contracts short, you have effectively locked in a selling price for 50 shares over the contract period, protecting you if the spot price falls.
Practical Example: A Simple Hedge in Action
Let's assume the current spot price is $50, and the relevant futures contract expiring next month is priced slightly higher at $50.50 (this difference is called the basis).
- Action 1: Establishing the Hedge (Today)**
You sell 5 XYZ futures contracts at $50.50.
- Scenario A: The Price Drops (Hedging Works)**
One month later, the economic announcement causes the spot price to crash to $45.
1. **Spot Loss:** You lost $5 per share on your 100 shares ($50 - $45). Total Spot Loss: $500. 2. **Futures Gain:** Since you sold short, you buy back the 5 contracts at the new lower price. Assuming the futures price tracks the spot price closely (it is now $45.50), you profit on the futures side.
* Profit per contract: $50.50 (Sell Price) - $45.50 (Buy Back Price) = $5.00 gain. * Total Futures Gain: 5 contracts * 10 shares/contract * $5.00 gain/share = $250 gain.
Wait, why is the futures gain ($250) less than the spot loss ($500)? Because you only hedged 50 shares worth of risk (5 contracts). You protected half your position.
- Net Loss after Hedging: $500 (Spot Loss) - $250 (Futures Gain) = $250 net loss.
- If you had *not* hedged, your loss would have been $500. By partially hedging, you cut your potential loss in half.
- Scenario B: The Price Rises (The Cost of Hedging)**
One month later, the economic news is positive, and the spot price rises to $55.
1. **Spot Gain:** You gained $5 per share on your 100 shares. Total Spot Gain: $500. 2. **Futures Loss:** You must buy back the 5 contracts at the higher price ($55.50 if the basis holds).
* Loss per contract: $55.50 (Buy Back Price) - $50.50 (Sell Price) = $5.00 loss. * Total Futures Loss: 5 contracts * 10 shares/contract * $5.00 loss/share = $250 loss.
- Net Gain after Hedging: $500 (Spot Gain) - $250 (Futures Loss) = $250 net gain.
If you had *not* hedged, your gain would have been $500. The cost of your insurance (the hedge) was $250 of potential upside gain. This is the trade-off: you sacrifice some potential upside to protect against downside risk.
Using Indicators to Time Exits and Re-Hedges
A hedge is not permanent. You must decide when to close the futures position—this is when you "un-hedge." Technical indicators can help you time this exit. When the market signals that the temporary downward pressure is over, you should close your short futures position.
Here is a simplified look at how common indicators might influence your decision to close the hedge (buy back the short futures):
| Indicator | Signal to Close Short Hedge (Buy Back Futures) |
|---|---|
| RSI | RSI moves strongly out of oversold territory (e.g., crosses above 30 or 40) |
| MACD | MACD line crosses above the Signal line (a bullish crossover) |
| Bollinger Bands | Price closes above the middle Moving Average band (often the 20-period SMA) |
If you were hedging against a drop, and you see strong bullish signals from the RSI, MACD, or Bollinger Bands, it suggests the downward move you feared might be over. It is time to close your short futures position to avoid losing money if the price starts rallying strongly while you are still short.
If you are managing risk related to What Are ESG Futures and How Do They Work?, the same principles apply, but the underlying asset and market dynamics change.
Psychological Pitfalls and Risk Notes
Hedging introduces complexity, which can lead to psychological errors.
1. **Over-Hedging or Under-Hedging:** Beginners often hedge too much, eliminating all profit potential, or hedge too little, leaving them exposed. Stick strictly to your predetermined percentage (e.g., 50%) until you gain experience. 2. **Forgetting the Cost:** When the market moves up while you are hedged (Scenario B), it feels like you are losing money on the futures trade, even though your spot holding is gaining more. Remember the hedge is insurance; you pay a premium (lost upside) for protection. 3. **Basis Risk:** In the example above, we assumed the spot price and futures price moved together perfectly. In reality, they might diverge temporarily. If the basis widens against you while you are hedged, you could experience a small loss on the hedge that wasn't perfectly offset by the spot move. This is known as basis risk. 4. **Liquidation Risk:** If you are using margin to hold your futures position, ensure you understand the margin requirements. If the market moves unexpectedly against your futures position (e.g., if you were wrong about the direction and the price shot up instead of down), you might face a margin call or even Liquidation in Futures Trading. Always keep sufficient margin available. For more on safe trading practices, review The Future of Crypto Futures Trading for Beginners.
Hedging is a proactive tool. It turns uncertainty into a known cost (the cost of the protection) or a known opportunity cost (the lost upside). Start small, understand your contract size, and always monitor when your hedging thesis expires.
See also (on this site)
- Balancing Spot and Futures Risk
- Using RSI for Entry Timing
- MACD Crossover Exit Strategy
- Bollinger Bands Volatility Check
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