With strong growth in the tech sector, everyone’s talking about the FAANG stocks (Facebook, Amazon, Apple, Netflix and Alphabet’s Google). These stocks are actively traded and widely followed. Another widely followed growth stock, Tesla has entered the arena with significant gains in the last year.

The MICRO NYSE FANG+ Index Futures Contract (MICRO FANG+ Futures) provides a way to trade an index based on the FAANG stocks and five other leading tech/growth issues, including Tesla. The futures contract is actively traded on ICE Futures U.S. Since the contract size is considerably smaller than most other stock index futures, it allows for greater flexibility, cost efficiency and accessibility for a wide range of participants.

The NYSE FANG+ Index has displayed an overall total return greater than 350% for the period 1/1/2017 through 12/31/2020. Its performance is even more impressive given that only two of the NYSE FANG+ Index stocks pay dividends.

Looking at just the last few months, the NYSE FANG+ Index has outperformed the overall market as measured by the S&P 500. The sharp rise in Tesla (Nasdaq: TSLA) has been one of the key drivers in the NYSE FANG+ Index’s performance - see table below.

16-Nov 22-Jan % change
TSLA 408 847 107.6%
FNG 5,510 847 22.2%
S&P 500 3,627 3,627 5.9%

An investor holding a portfolio of growth stocks including TSLA that correlates closely with the FANG+ Index might be concerned that a pullback is overdue and is looking for ways to protect against a potential short-term downside move. Obviously, selling all or part of the portfolio including TSLA is always an option. However, transaction costs and tax implications - (short term or long-term capital gains) - need to be considered. Another approach may be to use MICRO FANG+ futures as a hedge to help provide downside protection.

Portfolio Hedging with the Micro NYSE FANG+ Futures Contract

What is Hedging?

Hedging is a strategy employed to offset losses in one asset by taking an opposite position in a similar or related asset. Futures contracts are an ideal choice for hedging in many asset classes, including commodities and securities. In simplest terms, a futures contract allows an investor to buy or sell a specific asset at a predetermined time and price. As discussed below, an investor looking to protect an investment can simply buy or sell a futures contract to help protect the asset against losses for a specified period of time.

The Simple Hedge Example

Assume an investor is holding a portfolio consisting of the FAANG stocks, including TSLA, and other growth issues. Further, it is determined that the portfolio correlates very highly with the NYSE FANG+ Index. Again, the investor is concerned with the extent that TSLA, as well as his overall portfolio, has sharply outpaced the market. In order to obtain downside protection against a pullback in his portfolio, the investor wishes to use MICRO FANG+ Futures as a hedging vehicle. The current value of the portfolio is $100,000 and the value of a MICRO FANG+ Futures Contract is $32,015 ($5 x 6,403). As a simple hedge, the investor could simply sell an equal notional value of MICRO FANG+ Futures vs. the notional value of the portfolio. In this case, 3 MICRO FANG+ Futures would be sold (100,000/32,015) = 3.12. Below is an example of the results of this hedge assuming a 5% move in both the portfolio and MICRO FANG+ Futures.

Portfolio Value Gain/Loss MICRO FANG+ Futures Gain/Loss Net Gain/Loss
Up 5% $5,000 ($4,802) $198
Down 5% ($5,000) $4,802 ($198)

Several key points regarding this simple example:

  1. It is likely that price movements in the portfolio and the MICRO FANG+ Futures will not perfectly match. While it is assumed that a high correlation exists between the portfolio and index compositions, there will exist some variability between the two positions. Volume flows in both the underlying stocks and the futures can impact the performance of one leg vs the other. Also, the fact that the hedge ratio has to be rounded to the nearest whole number of futures contracts introduces some additional variability between the positions.
  2. While not a perfect hedge, if the expectations are correct, the portfolio will be insulated to a large extent from a decline in the market. The losses from the portfolio holdings will be offset by gains from the short MICRO FANG+ Futures position. The investor’s portfolio will remain intact and a decision can be made in the future when the hedge should be partially of fully removed.
  3. Of course, if expectations about a market decline are incorrect, the investor will be forfeiting potential upside gains by holding a hedged position. In this example, the investor would be forfeiting a 5% gain in his portfolio by electing to hedge the position. In this scenario, the investor needs to remember that the underlying rationale for the hedge was due to the original expectations that the portfolio was due for a relatively large pullback.

The Beta Hedge Example

Beta is a statistical measure of an individual stock or portfolios volatility relative to the overall market or a specific market index - in this case the NYSE FANG+ Index. Beta is used in the capital asset pricing model (CAPM). This model has been widely used for decades as a measure of the volatility of a security or portfolio relative to the overall market or a specific index as a whole.

A positive beta indicates that a stock or a portfolio moves in the same direction as the market. A beta of 1.0 indicates that historical price movements in the stock or portfolio have perfectly matched those in the Index. A beta greater than 1 indicates that the performance of the stock or portfolio has been more volatile than the index to which it is being compared. For example, a beta of 1.2 indicates that over time the value can be expected to change 120% more than the underlying market or index. Technology and small cap stocks often have betas greater than 1.00 relative to the overall market. A beta lower than 1 indicates that the performance of the stock or portfolio has been less volatile.

It should also be noted that some stocks and industry groups can at times have negative betas. This reflects the fact that there is an inverse correlation with the market. Gold stocks are often cited as an example of stocks that will decline (advance) when the market advances (declines).

Given that beta provides a statistical representation of a stock or portfolio’s relative volatility, it is often used by investors and portfolio managers to develop an appropriate hedging strategy for correlated index products. Specifically, an investor looking to hedge a stock portfolio with MICRO FANG+ Futures would determine the proper hedge ratio by dividing the portfolio value by the MICRO FANG+ Futures value and multiplying by the beta of the portfolio relative to the NYSE FANG+ Index.

(Portfolio $ Value/MICRO FANG+ Futures $ Value) x Beta = Hedge Ratio

As an example, consider an investor holding a portfolio of the following FANG+ Futures stocks.

Price Shares $ Value
TSLA 846.9 50 $42,345.00
AAPL 139.07 100 $13,907.00
NFLX 565.17 50 $28,258.50
FB 274.5 100 $27,450.00
Total $111,960.50

Given the sharp run-up in the market since last year, the investor is concerned about a near term pullback of his holdings. He is especially concerned about TSLA which has significantly outpaced the other stocks. He views any decline as short term and does not want to liquidate some or all of his holdings. He looks to use MICRO FANG+ Futures as the appropriate hedging vehicle for his position and determines the appropriate beta for the portfolio vs. MICRO FANG+ Futures is 1.5. The hedge ratio is calculated as 5.25.

($111,960/$32,015) x 1.5 = 5.25

The beta of 1.5 indicates that the portfolio on average will have a 150% greater move than the underlying NYSE FANG+ Index. By selling 5 MICRO FANG+ Futures, the volatility of the portfolio is taken into account when determining the hedge.

To illustrate, the following provides a hedge example assuming that MICRO FANG+ Futures drop 10% and the portfolio drops 15% as expected.

FANG+ 6,403
$ Notional Value - 5 contracts $160,075
10% decline -640
Gain from short 5 futures1 $16,000
Portfolio $111,960
15% decline2 ($16,794)

11640 x $5 multiplier x 5 contracts.

2Assumes the portfolio value declines in line with the 1.5 beta

It’s important to note that the beta (hedge ratio) will likely not remain static over the course of the hedge. It is based on historical data and provides a representation of the relative volatility between the portfolio and the NYSE FANG+ Index at that point in time. In addition, note that the beta of the stocks and portfolio can vary depending on the timeframe one uses to determine the calculation (i.e. 1 year beta, 3 year beta, etc.). The hedge needs to be closely evaluated over time and of course the hedging coverage can be reduced or expanded by buying/selling MICRO FANG+ Futures.

Important considerations:

The above examples demonstrate how one can utilize MICRO FANG+ Futures as a simple hedge and how one can use the widely used metric called beta to manage risk for equity portfolios. While a futures hedge that is properly established can help insulate an investor from losses, futures trading is not for everyone. Investors should have knowledge of how futures contracts and markets operate, and how to calculate the relative beta value between a portfolio of individual stocks and the MICRO FANG+ Futures before engaging in such risk management strategies. In addition, it’s important to keep in mind the following:

  1. If expectations about a market decline are incorrect, the investor will not only be forfeiting potential upside gains by hedging using this strategy, an investor could also suffer overall losses as a result of the futures position. In the above example, the notional value of the futures position exceeds the value of the portfolio and the price change of any individual stock held in the investor’s portfolio may not coincide with the overall price change of the MICRO FANG+ Futures position. As a result, an investor could realize significant losses from the short futures position if the index price were to rise. These losses may not be offset by gains in the investor’s portfolio.
  2. The beta of any individual stock and a portfolio is not static. It will change in different market conditions as will the comparative beta between the portfolio and the MICRO FANG+ Futures position. Betas will be sensitive to the specific time frame selected to determine its value.
  3. Given these factors, a beta hedge needs to be closely monitored and needs to be based on how much market risk the investor is willing to accept.

Disclaimer

This article is provided for informational and educational purposes only. This article may include observations made by Intercontinental Exchange, Inc., ICE Futures U.S., Inc., ICE Data Indices, LLC and/or any of their affiliates of general market movements and trends, but nothing herein is intended to be a solicitation or a recommendation to buy, sell or hold securities or futures contracts. Intercontinental Exchange, Inc., ICE Futures U.S., Inc., ICE Data Indices, LLC and/or their s affiliates do not provide legal, tax, accounting, investment or other professional advice. Clients should consult with an attorney, tax, or accounting professional regarding any specific legal, tax, or accounting situation. The article described general investment strategies, which do not take into account any of the specific needs or financial circumstances of any person, entity or group of persons and should not be considered investment advice. All information provided by Intercontinental Exchange, Inc., ICE Futures U.S., Inc., ICE Data Indices, LLC and/or their affiliates, including without limitation, any materials that describe any Index, is of general nature only.

Futures trading IS NOT suitable for all investors and involves the risk of loss. Due to the leveraged nature of futures trading and, it is possible to lose more than the amount deposited in a position. Traders should not risk more funds than they can afford to lose without negatively affecting their lifestyles and should only devote a small amount of their available funds to each trade. All references to options refer to options on futures.

NYSE FANG+ Index has been licensed for use in connection with MICRO NYSE FANG+ Index Futures. The MICRO NYSE FANG+ Index Futures Contract is not sponsored, endorsed, sold or promoted by ICE Data Indices, LLC. ICE Data makes no representations or warranties (i) regarding the advisability of investing in securities or futures contracts, or (ii) that any such investment based upon the performance of the NYSE FANG+ Index particularly, or the ability of the NYSE FANG+ Index will track general stock market performance.

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