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There are many ways to protect a stock portfolio from losses during a bear market.

The simplest option would be to sell all positions. However, depending on the size of the portfolio this entails high transaction costs and is not very practical, because the positions will have to be rebuilt if one wants to continue participating in the market at a later date, which in turn generates additional transaction costs. Beyond the costs, there are other reasons why investors prefer to hedge their portfolio—or individual equity positions—against price declines rather than sell them: for example, investors may wish to keep exercising their voting rights and not forgo dividend income.

The following example shows how a portfolio of Swiss equities valued at CHF 10,000 can be hedged against falling prices. An analysis of the portfolio’s stocks indicates that it should track the Swiss Market Index (SMI®) closely, so the portfolio can be hedged with SMI® Mini-Futures or SMI® Knock-Out Warrants. However, hedging can only be performed approximately, because it entails costs and the correlation between the portfolio and the index is rarely 100 % in practice.

For the sake of simplicity, we will limit the example to portfolio hedging with SMI® Mini‑Shorts. However, the same method can also be applied 1 : 1 to hedge with SMI® Knock‑Out Puts.

Portfolio hedging with SMI® Mini-Shorts

1. Objective

An investor wants to protect his SMI® portfolio, worth CHF 10,000, against future price declines.

2. What can the investor do?

The investor can buy Mini-Short Certificates on the SMI® (index level: 12,000 points). These Mini-Short Certificates increase in value when the SMI® falls and decrease in value when the SMI® rises. The following SMI® Mini-Short Certificates are offered:

It should be noted that SMI® Mini‑Shorts have a stop‑loss level. When the SMI® reaches or exceeds this price level, the products will expire and the hedge will no longer be effective. The closer the stop‑loss level is to the current SMI® level, the cheaper each individual SMI® Mini‑Short is, and consequently the overall hedging position becomes cheaper. However, in that situation there is a risk that the hedging position will be stopped out quickly, and the liquidation amount (residual value) will be paid out to the investor. Consequently, the investor would again be exposed to the full market risk of his SMI® portfolio – until a new hedge is put in place or the SMI® portfolio is sold.
When selecting the SMI® Mini‑Shorts to be used for hedging, it is therefore important to ensure that the stop‑loss level is set sufficiently above the current SMI® level.

For the calculation below, we will work on the basis of the SMI® Mini-Short with a leverage of 8.

3. Calculation of the required number of SMI® Mini‑Shorts

The number of SMI® Mini-Shorts required for the hedge can be calculated using the following formula:

Number of SMI® Mini-Shorts = (Value of the portfolio / Current index level) x Ratio

(10,000 / 12,000) x 500 = 416.67 => 417 (rounded)

For the hedge, 417 SMI® Mini‑Shorts are required.

4. Possible scenarios after one month

Explanation of the table:
The value of the SMI® portfolio changes in line with the value of the SMI®. If the SMI® rises/falls, the value of the SMI® portfolio will increase/decrease as well. The price of the SMI® Mini-Future Certificate is calculated by the difference between the Financing Level of the SMI® Mini-Short² and the current index level of the SMI®, divided by the Ratio. This means the price of the Mini-Short Certificate increases/decreases when the SMI® falls/rises. The value of the hedging position is calculated by multiplying the price of one SMI® Mini‑Short Certificate by the number of SMI® Mini‑Short Certificates held (here: 417 units).

The total shown at the bottom of the table is the sum of the value of the SMI® portfolio and the value of the SMI® Mini‑Short Certificates.

5. Conclusion

By purchasing 417 SMI® Mini‑Shorts, the portfolio is protected against price drops for as long as the hedging position remains in place – until the hedge is sold again or the SMI® reaches the stop‑loss level and the SMI® Mini‑Shorts are knocked out.

The difference between the total value for each scenario and the total value of the initial situation corresponds to the accrued financing costs² of the hedging position over the one‑month hedging period.

Detailed information on how Mini‑Futures work and additional hedging examples can be found in our product brochure.

¹ The difference in the costs is due to rounding.
² In the present example, the financing level declines during the one‑month observation period from 13,500.00 to 13,447.79 because of the accrued financing costs.