How to hedge Short Futures Position using options ?

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In this post I am trying to answer a question asked by my trader friend who wants to capitalise of long term bearish view with Short Futures position, but want to explore how it can be hedged using options to safegaurd against and dead-cat bounce from the fall.

Scenario: Let’s say I expect the markets to go below 4800. Currently being at 5220.
Case: What if I short August 2010 Futures of Nifty. Let’s say 200 Quantities. Now if market goes against me in short term, I do keep faith in my system and hold my position. Obviously this come with a cost – Stress.
Now what can I do here with options to lower my risk and my stress levels. If I am short on August 2010 Futures, should I buy August calls for protection? How do I structure this?

The Short futures position is a –ive Delta i.e. bearish position. Hence to hedge it, we need to create +ive delta legs i.e. bullish leg. There are various ways to use options to hedge this Short Future position. Some of them are
1) Buy Call – selection of right strike price, right expiry month will determine the cost that you will pay to hedge this position. In my view, you would certainly be having key decision making levels to monitor, and the time expected to reach those levels. That could help in selecting right Call option. Say your decision point is break of 5400 level and it might happen in next 20 days i.e. market should make move in either direction in next 20 days, then you can buy 5200 call , July Expiry.
Problem with this approach is that it will loose time value, even when market goes sideway and your futures position is stuck in a range.

2) Buy Bullish CALL Spread – By using spreads, you are creating the bullish leg, at the same time reducing the negative impact of time decay, and volatility drop on option price.

3) Short Put – You can sell a put again Short Futures position. In options, Short put has same risk reward profile as Long Call. Limitation is that this will provide you hedge only till the limit of premium collected. Advantage is that time will work in your favour as you gain due to time decay. You can short June month PUT, and once it reaches the expiry or the premium reduces to small amount, then u can short July Put. Quite possible if market falls by July, then you can short 5100 Put and collect more of time value, or can short 5200 PUT and lock the profit.

4) Sell Bullish PUT spread – By using spreads, you are creating the bullish leg, at the same time reducing the negative impact of time decay, and volatility drop on option price. Added advantage for this Credit Spread position is that time decay will work in your favour.

This will still leave you with the question of “How many option contracts ?”. This is a bit dynamic question and the answer depends on how much of risk you want to hedge. Short Futures have delta of -1, and ATM option have delta of 0.5. So to hedge 100% and create delta neutral position, you would need to buy 2 Calls to create bullish leg with delta of +1. This will give you delta neutral position, atleast for now.
As underlying moves, the delta of Call will change and you will end-up with open Delta position and hence you will have to adjust the position again.

As the spreads have lower then 0.5 delta, you might need to trade more contracts.

Advantage of this is that depending on your risk management parameters, statistical knowledge of market behaviour and current market conditions, you can adjust the degree of hedging that u need. Just keep in mind, any hedged position will compromise on the reward of main trade hence it is fine trade-off decision.

My personal choice is to use market’s money as much as possible to hedge my position hence I go for Short Put, or sell Bullish PUT spread.
This gives me choice to rollover to shift strike price so that I get most time value to hedge the risk, or to lock any accumulated profit.

Hope this helps you and gives you idea on how to hedge your shorts. Feel free to leave comment if you need any further clarification.

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2 Comments on “How to hedge Short Futures Position using options ?”

  • Raunak Agarwal
    19 June, 2010, 21:58

    Thanks Anup. Even on a vacation am glued to your site. 

    Tc

  • 19 January, 2012, 3:21

    SIR
    PLEASE  NAME ANY BROKERAGE HOUSE WHICH PROVIDE SHORT SELLING IN NIFTY OPTION AT LESSER MARGIN IN INDIA.

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