DEFINITION of Futures Equivalent
The futures equivalent is the number of futures contracts needed to be equivalent with a speculative option position, in order to hedge it. The futures equivalent can be calculated by taking the aggregate delta associated with an options position. This term only applies to options where the underlying security is a futures contract, such as options on stock indexes such as the S&P 500, on commodities futures, or on currency futures.
If a trader determines his futures equivalent, he or she can then buy or sell the appropriate number of futures contracts in the market in order to hedge their position and become delta neutral.
BREAKING DOWN Futures Equivalent
This term futures equivalent is generally used to refer to the equivalent position in futures contracts that is needed to have a risk profile identical to the option. This delta is used in delta-based hedging, margining, and risk analysis systems. Delta based margining is an option margining system used by certain exchanges. This system is equivalent to changes in option premiums or to changes in future contract prices. Futures contract prices are then used to determine risk factors on which to base margin requirements. A margin requirement is the amount of collateral or funds deposited by customers with their brokers.
Example of Futures Equivalents in Options Hedging
Most commonly, the futures equivalent is used in the practice of delta hedging. Delta hedging involves reducing or removing the directional risk exposure established by an options position by taking an opposite position in the underlying security. For example, if a trader has an options position in gold options that amounts to +30 deltas in terms of futures equivalents, he or she could sell 30 futures in the market and become delta neutral. Being delta neutral means that small changes in the direction of the market produce no profit or loss for the trader. Here, if the price of gold increases by 1%, the options position will gain approximately 1% while the short futures will lose 1% - netting out to zero.
Of course, options are not linear derivatives and their deltas will change as the underlying moves - this is known as the option's gamma. As a result, the futures equivalents will change as the market moves, so if the gold market moves up by 1%, while the position may not have made or lost any money, the futures equivalent may have moved from zero for the hedged position to +5. The trader would then need to sell five more futures contracts to return to delta neutral. This process is called dynamic hedging, or delta-gamma hedging.