Why Options Are Better Than Futures For Hedging
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Jason Ng
Apr 20, 2013, 8:30:05 AM4/20/13
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Article Title: Why Options Are Better Than Futures For Hedging
Author: Jason Ng
Word Count: 529
Article URL: http://www.isnare.com/?aid=510207&ca=Finances
Format: 64cpl
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Futures trading can be used for two main purposes; Speculation and Hedging. While most retail futures traders get involved in futures trading for the purpose of leveraged speculation, it cannot be forgotten that the true purpose of futures contracts is for the purpose of hedging.
Hedging using futures is technique most professional money managers use for decades. However, there is one main problem with hedging using futures and that is the fact that the settlement price of futures contracts isn�t the actual spot price of their underlying asset. That�s right. In other words, the price of the underlying asset used to determine the worth of each futures contracts isn�t the actual price of the underlying asset but a price derived from the actual price known as the �Settlement Price�. The problem with settlement price is that it can vary significantly from the actual price of the underlying asset and this difference in pricing may cause problems with hedging precisely using futures contracts.
Settlement price is determined at the end of each trading day or trading period by various methods, including price averaging across a certain period, and reflects the future price expectation of the underlying asset at various expiration months. This is why futures contracts of different months have a different price even though they are all based on the same underlying asset. In fact, some futures contracts may end up lower on days where the spot price of the underlying asset actually went up!
As a result of this tracking error between the settlement price and the actual spot price, it is nearly impossible to hedge a position to delta neutrality completely using futures.
This is also why options are becoming the new favorite hedging instrument of professional portfolio managers and are used much more commonly in stock hedging than their single stock futures counterpart.
Options base their price on the actual price of the underlying asset itself instead of a derived price of the underlying asset. As such, options are capable of the precise level of hedging that futures are not quite capable of.
Traditionally, futures contracts have been used for price protection between buyers and sellers of a particular commodity. By entering into a contract to trade the commodity at a specific price right now, buyers are protected against price hikes and sellers are protected against price drops. This is the hedging function that exchange traded futures still perform but the fact that the settlement price of a futures contract only converges with the spot price of the actual underlying asset close to or on expiration date itself, it is hard to use futures for precise short term hedging that may last only days and comes nowhere close to the expiration date.
Derivatives instruments such as futures and options are originally designed as hedging tools. As the demand for highly precise hedging over very short periods of time increases, futures are slowly becoming less popular compared to options in terms of non-commodity hedging.
Learn more about options trading at Optiontradingpedia.com and futures trading at Futurestradingpedia.com .
About The Author: Jason Ng is the Founder and Chief Option Strategist of Masters 'O' Equity Asset Management ( http://www.mastersoequity.com ) and author of an Futures Trading education site, http://Futurestradingpedia.com.
Please use the HTML version of this article at:
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Please consider this free-reprint article written by:
Jason Ng
*****************************
IMPORTANT - Publication/Reprint Terms
- You have permission to publish this article electronically in free-only publications such as a website or an ezine as long as the bylines are included.
- You are not allowed to use this article for commercial purposes. The article should only be reprinted in a publicly accessible website and not in a members-only commercial site.
- You are not allowed to post/reprint this article in any sites/publications that contains or supports hate, violence, porn and warez or any indecent and illegal sites/publications.
- You are not allowed to use this article in UCE (Unsolicited Commercial Email) or SPAM. This article MUST be distributed in an opt-in email list only.
- If you distribute this article in an ezine or newsletter, we ask that you send a copy of the newsletter or ezine that contains the article to http://www.isnare.com/eta.php?aid=510207
- If you post this article in a website/forum/blog, ALL links MUST be set to hyperlinks and we ask that you send a copy of the URL where the article is posted to http://www.isnare.com/eta.php?aid=510207
- We request that you ask permission from the author if you want to publish this article in print.
The role of iSnare.com is only to distribute this article as part of its Article Distribution feature ( http://www.isnare.com/distribution.php ). iSnare.com does NOT own this article, please respect the author's copyright and this publication/reprint terms. If you do not agree to any of these terms, please do not reprint or publish this article.
*****************************
Article Title: Why Options Are Better Than Futures For Hedging
Author: Jason Ng
Word Count: 529
Article URL: http://www.isnare.com/?aid=510207&ca=Finances
Format: 64cpl
Contact The Author: http://www.isnare.com/eta.php?aid=510207
Easy Publish Tool: http://www.isnare.com/html.php?aid=510207
*********************** ARTICLE START ***********************
Futures trading can be used for two main purposes; Speculation and Hedging. While most retail futures traders get involved in futures trading for the purpose of leveraged speculation, it cannot be forgotten that the true purpose of futures contracts is for the purpose of hedging.
Hedging using futures is technique most professional money managers use for decades. However, there is one main problem with hedging using futures and that is the fact that the settlement price of futures contracts isn�t the actual spot price of their underlying asset. That�s right. In other words, the price of the underlying asset used to determine the worth of each futures contracts isn�t the actual price of the underlying asset but a price derived from the actual price known as the �Settlement Price�. The problem with settlement price is that it can vary significantly from the actual price of the underlying asset and this difference in pricing may cause problems with hedging precisely using futures contracts.
Settlement price is determined at the end of each trading day or trading period by various methods, including price averaging across a certain period, and reflects the future price expectation of the underlying asset at various expiration months. This is why futures contracts of different months have a different price even though they are all based on the same underlying asset. In fact, some futures contracts may end up lower on days where the spot price of the underlying asset actually went up!
As a result of this tracking error between the settlement price and the actual spot price, it is nearly impossible to hedge a position to delta neutrality completely using futures.
This is also why options are becoming the new favorite hedging instrument of professional portfolio managers and are used much more commonly in stock hedging than their single stock futures counterpart.
Options base their price on the actual price of the underlying asset itself instead of a derived price of the underlying asset. As such, options are capable of the precise level of hedging that futures are not quite capable of.
Traditionally, futures contracts have been used for price protection between buyers and sellers of a particular commodity. By entering into a contract to trade the commodity at a specific price right now, buyers are protected against price hikes and sellers are protected against price drops. This is the hedging function that exchange traded futures still perform but the fact that the settlement price of a futures contract only converges with the spot price of the actual underlying asset close to or on expiration date itself, it is hard to use futures for precise short term hedging that may last only days and comes nowhere close to the expiration date.
Derivatives instruments such as futures and options are originally designed as hedging tools. As the demand for highly precise hedging over very short periods of time increases, futures are slowly becoming less popular compared to options in terms of non-commodity hedging.
Learn more about options trading at Optiontradingpedia.com and futures trading at Futurestradingpedia.com .
About The Author: Jason Ng is the Founder and Chief Option Strategist of Masters 'O' Equity Asset Management ( http://www.mastersoequity.com ) and author of an Futures Trading education site, http://Futurestradingpedia.com.
Please use the HTML version of this article at:
http://www.isnare.com/html.php?aid=510207
*********************** ARTICLE END ***********************
- To distribute your articles go to http://www.isnare.com/distribution.php
- For more free-reprint articles go to http://www.isnare.com
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