By Alka Banerjee
Index derivatives exist for all asset classes, and over time their use has grown exponentially for a variety of purposes. Still, many myths abound that their chief function is for speculative activity. The ability to leverage by investing a small amount to gain exposure to a much larger investment is the key benefit of index derivatives. While index futures have a symmetric impact on portfolio returns, index options can have an asymmetric impact. Both are valuable, cost-efficient tools for a number of reasons for a portfolio manager.
A large exposure can be obtained in a portfolio with a small amount of margin investment, and the potential for returns is magnified with a far smaller investment, making them quite cost-effective. Their liquid nature and ease of trading make them the number one tool for hedging and managing exposure. Derivatives can cover for downside risk when large exposure exists in a portfolio long on equities. On the other hand, if an investor has shorted a large number of single securities, then a single index call option can provide a great hedge against an inverse market move.
If an investor has large cash holdings that he or she wants to use for buying stocks after further research, a quick and easy way to deploy the funds is to go long on an index futures contract or buy a call option. This provides the exposure the investor is ultimately looking to gain, buys time to do the research, costs far less, and manages the price impact of large trading in a short time frame. Small purchases over time would reduce the effect over prices and avoid creating a market impact.
Similarly, when a large number of securities needs to be sold off, buying an index future gives time to ease in the selling over time and to dampen price pressure. As cash positions are built over time, the index future maintains the overall security exposure until further investment decisions are made. This approach makes sense for active and passive investors, where large trades can be counterbalanced with the use of index futures or options bought at a low cost by the investor to avoid having large price-affecting shifts in exposure.
Another interesting use of derivatives is when the portfolio has a gap in exposure to a particular sector or size. For example, if the portfolio lacks small-cap investments or exposure to a specific sector, index futures or options can be bought to cover those gaps rather than trading single small assets in this space at a much higher trading cost. In sum, index derivatives are cost-effective and are a great tool for tactical use of assets in a portfolio. Trading them for speculative activity is actually riskier and a less-effective use of this financial tool.