Index futures can reduce part of a portfolio's market exposure, but a hedge is rarely perfect. The portfolio may not move like the index, futures basis can change and the required contract quantity may need rebalancing over time.
Define the risk being hedged
Decide whether the aim is to reduce broad-market beta, protect an event window or manage a temporary concern. A general desire to avoid loss is too vague to determine instrument, size and duration.
Estimate portfolio-index sensitivity
A portfolio concentrated in one sector may not track a broad index closely. Historical beta and correlation can inform the estimate, but relationships can change during stress.
- Portfolio market value
- Index contract value
- Estimated beta
- Desired hedge percentage
Include basis and expiry mechanics
The futures contract may trade above or below spot, and its basis can change before convergence into expiry. Rolling the hedge introduces a new contract and transaction costs.
Monitor mismatch and side effects
If the portfolio rises while the hedge loses, that can be the intended trade-off rather than failure. Review whether the hedge still matches portfolio value, composition and the original risk window.
Estimate a transparent hedge ratio
Document portfolio value, estimated beta, futures contract value and the percentage of market exposure intended to be reduced. Round contract quantity carefully because exchange lot sizes can make an exact ratio impossible.
Run the estimate under a change in portfolio value and index price. A hedge that begins near the target ratio can drift as the cash holdings and futures move differently.
- Portfolio value
- Estimated beta
- Contract notional value
- Desired hedge percentage
Define success and exit before hedging
A hedge can lose while the portfolio gains and still have served its purpose. Define the risk window, acceptable residual exposure and condition for removing or reducing the hedge before evaluating it.
Track dividends, basis, rollover cost and transaction charges. These can create performance differences even when the broad index relationship behaves as expected.
- Hedge objective
- Start and end condition
- Residual risk
- Carry and transaction cost