If nothing else, the 2020 coronavirus (COVID-19) pandemic reminded us of the importance of risk management. From late February through the end of April, unprecedented levels of volatility swept the world’s equity, commodity, and currency markets. Traders familiar with the principle of diversification and how to hedge with options protected their wealth and may have prospered.
Let’s take a look at how you can use equity index options on futures to guard against losses due to a stock market crash.
Equities Options on Futures 101: Contracts
If you have experience trading stocks, then you are aware of the vast number of alternatives in the market. Individual corporate shares, stock options, mutual funds, and ETFs (leveraged and inverse) are several of the most popular. For a broad view of American equities market performance, investors key a close eye on these four prominent indices:
- Dow Jones Industrial Average
- Standard & Poor’s 500
- NASDAQ Composite
- Russell 2000
On the Chicago Mercantile Exchange (CME), there are a host of contracts designed to mirror these four American equities indices. For stock traders learning how to hedge with options, it’s important to become familiar with the CME’s lineup of E-mini equities index products:
These four futures contracts provide traders the ability to engage American small-, medium-, and large-cap equities. Each contract also acts as the basis for a corresponding options chain. Known as futures options or options on futures, these contracts function much like traditional stock options, featuring countless strategic applications.
Using Options on Futures to Hedge Stock Market Risk
During the spring 2020 stock market crash, the leading American indices took a beating as participants attempted to price in COVID-19. This phenomenon was evidenced by the E-mini S&P 500 repeatedly hitting its initial 7 percent circuit breaker in March.
Diversification, or spreading holdings out across various asset classes and products, played a key role in weathering the COVID-19 financial storm. Astute investors knew how to hedge with options, and they diversified their portfolios accordingly. Here are two of the most popular options-based strategies for managing a market crash.
Buying In-The-Money (ITM) Puts
Perhaps the most basic way of hedging against a stock market crash is to buy in-the-money (ITM) puts on equities index futures. Buying a put gives the holder the right, but not the obligation, to sell a futures contract at a specific price on some forthcoming date in time. If you’re interested in how to hedge with options against a market crash, it’s worthwhile to learn all about buying ITM puts.
By buying an ITM put option, you can sell a futures contract at or near the current market price by or on some forthcoming date in time. If the market were to crash after you buy an ITM put, profits are theoretically unlimited. Further, the only assumed risk is the up-front premium you paid for the put option itself.
Assume that Erin the S&P 500 investor became leery of the market amid the late-February 2020 onslaught of COVID-19. Erin could have protected stock, ETF, or mutual fund holdings by simply buying an ITM E-mini S&P 500 put option. If she did this, gains generated by the put option in March 2020 could have largely mitigated losses taken in the stock market.
A straddle is an options strategy in which the trader simultaneously buys both put and call options with identical strike prices and expiration dates. In doing so, the trader secures exposure to the long and short side of the market, profiting from any directional bearish or bullish move.
During the run-up to the 2020 U.S. presidential election, let’s say that Erin the investor is uneasy about growing political uncertainty. On Oct. 1, 2020, Erin decides to put a straddle on the E-mini NASDAQ to hedge exposure to the tech and growth sectors. Erin simultaneously buys March 2021 E-mini NASDAQ calls and puts with a strike price of 11,500.25.
By executing the straddle, Erin has hedged exposure to the short side of the NASDAQ and added to the existing upside potential. If the market crashes, gains from the put will largely offset losses realized by NASDAQ holdings, and if the market rallies, gains from the call will be added to those of any NASDAQ holdings. Should the market remain flat, Erin will only absorb the cost of the call and put option premiums.
Hedgucation 101: How to Hedge with Options
For more information on the world of risk management, check out Daniels Trading’s e-book The Ultimate Guide To Hedging. In it, you’ll find vital information on futures, options, market analysis, and risk. The Ultimate Guide To Hedging is a great starting point for anyone interested in learning how to hedge with options and futures.