Futures and Options in Equity Portfolios

I had a really interesting question swing past my inbox from a reader named Chin Fu relating to Futures and Options and the risk-relationship they hold in equity portfolios. This is a really great area and is perhaps targeted at the more advanced Small Stocks readers than those who merely browse this site for general information. Of note, it is suggested that you read up a little on Markowitz Portfolio management for a solid understanding of this area before we dive too deep into this subject.

Future and Options affect both the risk and the ultimate return of the distribution of assets in an equity portfolio. The systematic and unsystematic risk of equity portfolios is definitively modified by using futures and options, and they obviously can change the level of cash inflow and outflows from a portfolio as differing hedging strategies are adopted. Typically, a dollar-for-dollar correlation exists between the changes in the underlying value of a security and the ultimate price of a relevant futures contract. This relationship effectively implies that being long in futures is the same as reducing the amount of cash from a portfolio. If we reverse this logic, then being short in a future contracts is the same as adding cash to the portfolio being managed. Evidently, a portfolio manager who has taken long futures positions will have done this in order to increase the exposure the portfolio to the underlying asset, while conversely, if a portfolio manager has taken short future positions then they are decreasing the portfolios exposure.

Therefore, a long position in a futures contract has the effect on the portfolios underlying assets by increasing the portfolios exposure to any resulting price changes of the asset. Shorting futures pretty much has the reverse effect in that it will decrease the exposure of the portfolio to any underlying assets. Of course, it really depends what the portfolio managers strategy is and what they are trying to achieve when managing the investment.

If we take a look at option contracts – they give the owner the right but not the obligation to buy or sell the underlying asset at a particular time in the future. Since options always provide this option whether or not the option holder decides to ultimately exercise the option, it infers that they do not have a proportioned impact on the returns of the portfolio – that is, they are not overtly exposed to the changes in futures prices and the underlying assets as we saw above. To illustrate, its pretty easy to see that buying a call option limits losses as you are buying the call with the hope that the stock price will rise, on the flip size, if you buy a put then when you also own the underlying security then you are effecting trying to mitigate any downside risk in the portfolio.

All in all there are some pretty clear differences and if you have some more questions in relation to this – then perhaps I will post some information on passive and active portfolio management. Either way drop a comment if you want more information.