How shorting stock index futures could save your downside

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Nairobi Securities Exchange trading floor. FILE PHOTO | NMG

If you buy political risk insurance on your business, you know that your losses would be covered in case of physical damage to your premises and looting, or loss of business due to precautionary closures associated with political violence.

Can you do the same with your portfolio? Yes, through shorting stock index futures, specifically the Nairobi Securities Exchange (NSE) 25 Index futures.

Using these futures, it is possible to protect your downside without the need to trade the actual securities (meaning you continue to benefit from dividend income). Plus, it is much faster and less expensive.

With the NSE 25 Index down 5.5 percent year to date, perhaps, it’s time investors learn the benefits of buying this portfolio insurance.

How do we execute? If your portfolio has a beta of 1.1 relative to the NSE 25, it means that if the NSE 25 rises by 10 percent, that portfolio will rise by 11.0 percent - in other words, it is riskier than the index.

Now, let's assume you have a portfolio that has a value of Sh1 million and you believe markets will continue to fall due to the rising political risk. You elect to hedge this portfolio using NSE 25 futures.

Using NSE 25 Index last Friday’s price of 2,981.8 points and a portfolio beta of 1.1, the following is the formula of calculating the number of contracts required to fully hedge this portfolio.

Simply take the portfolio value and divide it by the product of the NSE 25 contract’s size (set at Sh100) and the index price. The answer would be 3.35. If you multiply this result with the portfolio’s beta (1.1), you’d get the estimated number of contracts of 3.68 contracts (four contracts to round-off).

Note: A share’s beta is the measure of its relative volatility or risk versus the market. Therefore, a portfolio’s beta is the weighted average of the individual betas of the shares that make up the portfolio. Why is this hedging strategy useful?

Investors can offset the price risk in the underlying asset by taking an opposite position in the futures market. So, someone who is long the underlying asset will sell the equivalent number of futures contracts to hedge the risk (a short hedge).

Remember that unhedged positions are at risk from changes in the price of the underlying asset. Small traders can utilise the mini-version (the “big” NSE 25 Share index future is rather expensive). The notional contract value of one mini-contract is one-tenth of the size of the “big” NSE 25 index futures.

For the NSE, they should consider going beyond Open Interest and start disclosing the net positioning in NSE 25 Index futures (and for all its futures offering).

In my view, this would help hedgers know whether the market is net short (meaning more futures traders are betting that the index will fall than rise) or long (meaning more futures are betting that the index will rise than fall).

Open Interest, although helpful in gauging market activity around a contract, does not give much directional clarity.

Mwanyasi is the managing director Canaan Capital

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Note: The results are not exact but very close to the actual.