Many investors manage their portfolios using notional value because it's easy to understand
the cash value of their positions.
For example, if your portfolio is worth $500,000 and you want to hedge 30% of it using equity
index futures, it may be easier to calculate how many contracts you'd need using notional
value.
However, notional value doesn't account for how various types of positions in your
portfolio may respond to market movement differently.
For example, if you have the same amount of money invested in technology stocks as you
have in utility stocks, you could have similar notional values.
Technology stocks tend to be much more volatile than utility stocks, so you would need a technique
that allows you to measure the differences.
The problem with using notional value is that it treats all assets the same.
This can make hedging difficult because it's hard to know how much protection you need
if you don't know how much risk you're actually carrying.
One alternative to using notional value is a technique called beta weighting.
Beta represents how volatile one asset is compared to another.
Beta weighting allows you to measure your portfolio's risk relative to a single asset
or index like comparing apples to apples.
So, for example, if you want to hedge your portfolio with the E-mini S&P 500, you can
beta weight your portfolio to the ES and see all your positions' risk relative to the
movement of the S&P 500.
This can make it easier to determine how your portfolio might respond to a downswing.
Determining how much to hedge based on risk exposure rather than just notional value may
help you to more precisely calculate how much protection you actually need.
Now let's look at how beta weighting works and how to use it on thinkorswim paperMoney.
You can find the beta-weighting tool in the Position Statement section on the Monitor
tab.
To activate it, I'll select the Beta Weighting box.
Next, I'll enter the instrument I want to use as my benchmark.
For this example, we'll assume our portfolio generally tracks the S&P 500 and that we'd
want to use the E-mini S&P 500 futures contract to hedge, so I'll enter /ES.
To see the results, you'll need to have a Delta column in your Position Statement.
If you don't, it's easy to add one using the gear icon.
When you're beta weighting, delta indicates how much you stand to gain or lose, all else
being equal, if your selected benchmark changes 1 point.
Basically, it's a measure of risk exposure.
If you're bullish, you'll want to see more positive deltas.
If you're bearish, you'll want fewer positive, or even negative, deltas.
Now, on the Position Statement, each security has a delta.
If a position has positive deltas, it'll gain value if the benchmark goes up and lose
value if the benchmark goes down.
Positions with negative delta will do the opposite drop when the benchmark rises,
and rise when the benchmark falls.
This is one of the main benefits of beta weighting.
You can see the risk associated with each of your positions expressed in the same unit.
Here, you can see the total delta for the whole portfolio.
This sample portfolio has a delta of 447, which means the portfolio is estimated to
rise about $447 for every point our benchmark, the ES, rises.
It also estimates that the portfolio will fall $447 per point the benchmark falls.
So, how can we apply this to hedging a portfolio?
When beta weighting, think of hedging as an attempt to reduce your portfolio's delta.
If your portfolio has positive delta but you think the market might drop, consider reducing
your delta exposure.
You can do this by adding a position with negative delta, for example, a short index
futures contract.
If you know how many positive deltas your overall portfolio has and how many negative
deltas a short futures contract has, you can determine how many contracts to sell to hedge
your portfolio.
Let's walk through this calculation with our sample portfolio.
We can see here that our portfolio has 447 deltas.
So if I wanted to hedge my portfolio, one E-mini S&P 500 futures contract would add
negative 50 deltas.
Based on these numbers, if the S&P 500 fell one point, the original portfolio would be
expected to fall an estimated $447.
However, the portfolio with the hedge would only fall $396.
Of course, beta weighting doesn't stop the risk of timing the market that comes with
hedging.
You still have to determine when to close the hedge to avoid the drag that the contract
causes.
Remember, having higher deltas when the market turns bearish could also result in higher
losses.
Whereas, lower deltas when the market turns bullish could reduce your gains.
So, follow your investing plan to know when to open your hedge and when to close it.
You can see that beta weighting on thinkorswim paperMoney can be a valuable tool for determining
how much to hedge your portfolio.
Measuring your portfolio in terms of market exposure may help you hedge more effectively.