Futures vs. Options for Hedging

Discussion in 'Trading' started by saxon, May 21, 2002.

  1. saxon


    I am currently using index puts to hedge my stock portfolio. Would I be better off to short the index futures? Specifically, I am concerned about the "time decay" with options. Do futures lose value as time passes in the same way?

  2. Whether or not you should short index futures to hedge your portfolio would, I think, really depend on how corrolated it is to the broad market. Otherwise it's really questionable how much of a "hegde" selling an index is going to be.

    Although you normally pay a premium for futures that is assumed to cover the cost of carry, there isn't a "time decay" as with options, but you'll have to roll your position come the delivery date.

    Have you found hedging with options to be worthwile?
  3. saxon


    So far...so good. Today, for example, I recovered in my index puts about 50% of what my stock portfolio was down. Not 1-for-1, but it takes some of the sting out of a down market. And by putting only about 1% of my capital at risk.

    I use 3 different puts; SPX (large cap), MID (mid), and SML (small). I do not ALWAYS have a position in puts; only when some indicators I watch suggest that any of those three are vulnerable.

    Right now, I am long puts only in the MID and SML.

    What worries me is the "cost of carry", i.e. time decay. It is a much discussed topic in options, but not much talk of it in futures.

    Maybe the difference is that an option specifies a particular bias--up or down--while the premium in a futures contract, even in the back months, comes from the markets current assessment of where the cash will be at expiration. Could even be LOWER than the cash...I guess.

  4. There is premium decay on index futures. The ideal premium is the interest cost to buy all of the stocks in the index, minus the dividends those stocks pay. Things in futures aren't ideal so in addition to the time element, the premium also reflects futures traders' opinions on the future value of the index. So the premium may actually be positive or negative, though it typically hovers around the ideal premium value, aka fair value less index value.

    When you sell futures and hold a position overnight or longer you actually gain a benefit from this decaying premium (if the premium is close to ideal). When the front month futures contract expires, theoretically the premium should be near zero.